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    Systemic Risk Control Meets Adaptive Behavior

    I just struggled through what turned out to be an interesting paper, “The Dynamics of Financial Stability” by Cruz and Lind (March 3, 2011).  http://arxiv.org/pdf/1103.0717v1

    In it they examine the impact on systemic stability of changes in bank minimum capital requirements. 

    Their results provide a healthy challenge to some conventional thinking.  They find that following an increase in capital requirements crises may become more frequent and the magnitude of any crisis is just as unpredictable.    The increased capital requirements can also increase the tendency to too-bigness in banks. 

    They get these results by constructing a “preferential” network model (big banks are really big), which exhibits two “states”, namely stable growth and financial crisis, with a tendency in the system to hang out at the critical point between the two states. 

    The key bit of model dynamics here is that banks adapt their behavior following a mandated increased capital requirement by trying to maintain their profitability (i.e., return on capital). 

    The modeling approach here is (more than a bit) artificial.  I would not claim that this model represents the world as it really works.  But the paper is illustrative of the potential danger in oversimplifying the presumed solution to a problem. 

    Correctly anticipating adaptive behavior (by banks in this case) may be the Achilles heel of regulators and central planners.

    (I am ignoring the other Achilles heel, in which regulators and central planners are challenged to possess enough information about the economy’s “production” function – and individuals’ “utility” functions to enable them to properly set, at a very granular level, various economic levers, switches, and dials, so they can achieve the general or specific macroscopic policy outcomes they desire.  The challenge is immensely greater when taking the leap from viewing the economic system (and its components) as mechanical - that is, complicated like an engine - to viewing the system as exhibiting complex dynamics - like the weather. 

    Read “Economics and Knowledge” (http://bit.ly/fAS5Xi) and “The Use of Knowledge in Society” (http://bit.ly/dY7n2O) by Hayek to get a fuller picture of this challenge).  

    The results of the Cruz and Lind paper don’t prove (or disprove) anything.  But if they make us look a bit deeper into the role of complex dynamics in systemic stability and add a bit of circumspection to our actions aimed at mitigating future crises that’s a good thing.

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    1. belranto posted this
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Bel Ranto

belranto
Financial risk management in perspective...mine, that is.

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