Wednesday 7 May 2008

In favour of the narrow bank model?

Naked Capitalism has an insightful commentator. I'm not sure if I agree with all of this, but it is certainly a helpful perspective:

Perhaps a lesson to be learned here is that liquidity acts as an efficient conductor of risk. It doesn't make risk go away, but moves it more quickly from one investment sector to another.

From a complex systems theory standpoint, this is exactly what you would do if you wanted to take a stable system and destabilize it.

One of the things that helps to enable non-linear behavior in a complex system is promiscuity of information (i.e., feedback loops but in a more generalized sense) across a wide scope of the system.

One way you can attempt to stabilize a complex system through suppressing its non-linear behavior is to divide it up into little boxes and use them to compartmentalize information so signals cannot easily propagate quickly across the entire system.

This principle has been recognized in the design of software systems for several decades now, and is also a design principle recognizable in many other systems both natural and artificial (c.f. biology, architecture) which are very robust with regard to exogenous shocks. Stable systems tend to be built from structural heirarchies which do not share much information across structural boundaries, either laterally or vertically. That is why you don't die from a heart attack when you stub your toe, your house doesn't collapse when you break a window, and if your computer crashes it doesn't take down the entire internet with it.

Glass-Steagall is a good example of this idea put into practice. If you use regulatory firewalls to define distinct investment sectors and impose significant transaction costs at their boundary that will help to reduce the speed and amplitude of signals which will propagate from one sector to another, so a collapse in one of them will be less likely casue severe problems in the others.

It worries me that we’ve torn down most of these barriers in the last several decades in the name of arbitrage, forgetting that the price we paid for them in inefficiency was a form of insurance against the risk of systemic collapse. This is exactly what I would do if I wanted to take a more or less stable, semi-complex system and drive it in the direction of greater non-linearity.

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