A systems approach to the Global Financial Crisis

John Robb at Global Guerrillas writes:

In the case of the financial system, the simplified component of the bow-tie control system is money.

The regulatory system for these simplified components are markets (price discovery). Through this lens, what happened in the financial system is actually relatively simple.  The financial industry created a system called the shadow banking system (a notional value of $400 trillion ++), which is essentially a complex web of interconnected derivative contracts. 

These contracts are, by and large, NOT regulated by market mechanisms (they "derive" their value from other things, including market prices).  Instead, they are customized and complex.  These derivatives created a set of interconnections that bypassed the financial system's simple bow to directly connect inputs to outputs.

A systems approach and perhaps a bow-tie model is correct but his analysis and explanation does not really fit the crisis.  Why would new off balance sheet entities (shadow banks) create a more direct linkage between inputs and outputs than already existed?  Why did OTC derivatives suddenly become a problem when they have always existed along side the exchange traded instruments?

His analogy to the internet that places bits of data at the bow of the system is where John wanders off course.  Beyond the data bits, to work effectively the internet needs standards so that the programs that read and present to users display the received bits in the intended way.  As seen when upgrading or trying a new browser it is these evolving standards that lead pages to sometimes display incorrectly.

For the Global Financial Crisis the standards also came into play.  Investors misunderstood the borrowing levels for the large banks because the banks had moved assets and liabilities off balance sheet into "shadow banks".  Investors further misunderstood OTC derivative contracts because the ratings applied to the mortgage pools did not imply the same level of safety as it had in the past for standard debt.  Examples like this continue with new surprises like Lehman's Repo 105 transactions which were explicitly done offshore to bring another legal standard into the mix so that once again investors could not render the correct financial picture from company statements.

A second system element was the willingness of regulators to experiment with relaxed leverage restrictions.  There is no feedback loop - other than bankruptcy of individual firms - that restricts the amount of leverage in the system.  This is done instead by regulating the amount of capital that most be held and in some cases by specifying the amount of margin that needs to be posted on an individual transaction basis.  These rules were relaxed.  For instruments like no down payment home loans and total return swaps the lack of margin is explicit.  For other newer innovations, like AIG's CDS portfolio or the shadow bank entities used by banks like Citigroup, it seems likely that the regulators, like investors, did not have an accurate picture of the leverage involved.

These misunderstandings and relaxed lending standards compounded through feedback in a couple of ways.  Once the misunderstanding of leverage existed it was able to compound as too much reliance was placed on obligations from Lehman, Bear Stearns, AIG, AMBAC, and MBIA.  The increased leverage was primarily focused on property, leading to rising prices creating an illusion of safety and driving demand for more borrowing in the sector.   This was the primary driver of a higher than normal level of borrowing throughout the economy.

Seeing the system a bit differently than John, I diagnose different problems and solutions.  I view the primary causes of the crisis as inadequate lending limits and a lack of transparency in financial companies.  This lack of transparency was enabled by unnecessary complexity being represented as innovation.  In terms of re-regulating finance reform should focus on the following:

• Greater reliance on exchanges and margining.  Exchange cleared products are more likely to be standardised and are more accurately valued due to margin requirements and  more actively traded markets.
• A rethink of what is meant by financial innovation.  Too much of what was labeled innovation seems to have really been obfuscation leading to poor judgement by investors and regulators.  Some clear signs that this is happening are when the profits and valuation changes due to "innovation" are disproportionate to the stated benefit of the new product.  I.e. should slicing up and reselling banks' loan portfolios really lead  to the record real estate values and record profits for banks?  Standardisation and a long track record for a product should be given a lot more weight in terms of the capital required to be held against a product.
• Principles based reporting standards.   This fits with the point above as limiting the use complexity that is without purpose will also limit the tools available for misrepresentation.
• An overall limit on the level of credit that is acceptable for any given institution and for the economy as a whole needs to be set.  In avoiding risk of ruin all individuals do this and it is not clear that any better method can be established for companies or countries.  At some point leverage will always be too high and lead to bankruptcy and where exactly this point will be reached is unknown except with hindsight.