For example, in the UK, the financial sector had grown 76 per cent between and , outpacing all other sectors according to the National Statistics Economic and Labour Market Review. Consequently, national governance of financial institutions and processes became increasingly difficult as banks became more powerful lobbyers as the financial services industry grew increasingly profitable. Haldane a notes that pairwise correlations reached as high as 0. Based on seminal work in economic governance Keohane and Ostrom, ; Ostrom et al. However, in terms of regulatory restrictions on financial innovation and monitoring interdependencies, international cooperation was cursory in nature.
Although important, this new global regulatory focus obscured another significant systemic risk that arose at the level of the individual: the collective actions of what Clark et al. Circumvention of regulation was possible because of misaligned incentives at the level of the firm and individual financial actor. The incentives of traders operate to encourage them constantly to find ways to increase the volume of their trades, create ingenious new financial instruments and, because of the constraints posed by Basel, particularly to find new innovative trading strategies to offset risks Haldane, b.
The innovation of credit default swap derivatives allowed firms to outsource their risks to counterparties and effectively decouple risk from responsibility. This led to moral hazard, which Baker and Moss argue occurs when people in control of taking risks are more inclined to take larger risks because they do not bear the cost of failure.
As a result, individual actors had greater incentive to focus on network growth than network vulnerability, which has been shown to lead to systemic vulnerabilities in complex biological, technological and financial networks Saavedra et al. Saavedra et al. However, the generational gap between traders and regulators means that there is a significant skills mismatch between young innovative traders and the older regulators, many of whom do not have the knowledge to understand the complexity of new financial instruments or modelling.
Youth and innovation, motivated by mesmerising bonuses, won over seniority and rules.
The national and global regulators did not understand the complex underlying systemic risks festering under these new financial instruments, nor could they keep up with the pace of their innovation. As a result, the system was overwhelmed by innovation that sidestepped underwhelming regulation. Individual traders also may not have understood the ramifications of their own complex innovations Jervis, Modern behavioural economics stresses that there are limits to the extent to which people can understand complex instruments Shiller, In general, traders pragmatically legitimise their decisions based on classical economic models, such as the Efficient Market Hypothesis and Capital Asset Pricing Model to model how finance should work, not how it does work MacKenzie, Moreover, even if they did understand the consequences of their actions, they would have been aware that they were operating within global and national regulations, which did not outlaw credit derivative swaps or related transactions.
For individual traders, these were rational activities, even if the collective impact was powerfully destabilising.
The inability of national and global governance institutions to predict or regulate effectively the systemic risks underlying the financial crisis reflected a profound misunderstanding of the complex and fragile dynamics of the global financial system. As the global financial system became more complex, global institutions and economic analysis failed to evolve at the same pace.
Yet the current global response to the financial crisis has been inadequate, as it continues to fail to appreciate or deal with the underlying forces of systemic risk identified above. The massive increase in government spending, however, will exacerbate national and global imbalances in the medium term, and urgently requires more transformative global action.
The response also has raised moral hazard as the biggest financial firms have absorbed their competitors and are now even more interconnected and too important to fail. Indeed, as the failure of large banks in the future would lead to a write down of taxpayers' bailout funds, they are more likely to be saved by federal rescues. This could perpetuate or even increase excessive risk taking and the possibility of more severe systemic risks in the future by encouraging loss control instead of prevention Baker and Moss, The assurance of federal rescue also reinforces the view that economic policy orthodoxy need not fundamentally change, as indeed has been seen after the recent financial crisis Wolf, a.
National policy change in the US also reflects a continued lack of understanding of systemic risk.
Instead of consolidating regulation, the government has proposed the formation of a Financial Oversight Council and an additional council, which will overlay two additional regulatory bodies atop what already is an entangled web of US regulators Luce, This will not only decrease the efficiency of national systems of regulation; it will also undermine effective international coordination and global policy setting by increasing complexity.
The crisis served to accelerate the evolution of the G8 towards a G20, in what has been considered by many as a major step towards a new international financial architecture and reformed global economic governance regime Schmidt et al. The G20, however, remains tentative and without administrative capacity or executive authority, while the original G8 continues to attempt to assert its leadership in all matters other than finance.
To date, the G20 has failed to get to the roots of the crisis or to go beyond its coordinated fiscal stimulus and focus on corporate bonuses to develop a deeper and more lasting resolution. Furthermore, while the G20 is hailed above all else to be a more inclusive form of global governance, as the article by Woods in this issue identifies, in practice it remains little more than a tentative first step without multilateral legitimacy or authority Gros et al.
Without the institutional structure to manage diverse interpretations of the crisis, collective action problems could derail G20 progress, where increased interdependency may lead to increased friction rather than collaboration Schmidt et al. A key consideration is how to expand representation without compromising efficiency, with some arguing that 20 actors are already too many Wolf, Developing global governance systems that are representative and legitimate as well as effective in managing systemic risks is an extraordinary challenge.
As Simon , p. Global governance requires a radical structural change of the existing institutions tasked with systemic risk management in finance. The G20 has given the IMF added responsibilities to step up its supervision and new funds to pump into countries suffering the results of the crisis. However, in a world where economic globalisation has outpaced political globalisation Stiglitz, , even the best equipped of global financial institutions, like the IMF, will struggle to govern effectively because they cannot evolve rapidly enough to manage systemic risks.
The Financial Stability Forum has been renamed the Financial Stability Board, but it still has only a handful of staff and no executive authority or inspectorate, let alone sanction against countries that ignore it, as the US has done. At the same time, the proposed reforms of Basel II regulation appear equally inadequate, with powerful banking lobbies foreclosing any possibility of a fundamentally reformed regulatory response Lall, A fundamental regulatory shift is nowhere in sight and no international supervisory body has done more than make vague recommendations about the radical structural step changes needed.
Instead, institutionally rigid national and global economic governance regimes aim incrementally to tighten regulation to discourage complexity. He describes how regulatory agencies should embrace the robustness offered by complexity, and talk to innovators in order to contribute to the complex creative process and reduce system fragility. Although this is intellectually attractive, in practice it is likely to prove impractical and could lead to further instability.
In a world of regulatory arbitrage, where the traders have incentives to remain one step ahead of the authorities, the key question is whether and how innovation should be curtailed. The balance that must be struck between robustness and fragility should be central to the institutional response to the new realities of systemic risk. Lesson 1: With robustness comes fragility through network complexity and homogeneity. System fragility stemmed from governance gaps at the global, national and individual level.
The fragmented surveillance system created a space within which regulatory arbitrage could grow out of control of regulators and most traders who did not properly understand the systemic vulnerabilities caused by increased complexity and homogeneity.
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Understanding the topological robustness and complexity of a network depends on the dynamics of how these systems are formed and will fall apart, their assembly and disassembly processes Saavedra et al. This involves an understanding that nodes cannot be analysed in an additive manner, nor can they be analysed isolated from their interactions with other nodes within the broader network Jervis, Lesson 2: Governance gaps within and between global, national and local institutions exacerbate systemic fragility.
The second lesson draws on the tension within and between levels of financial governance ranging from the global to the local. In the absence of adequate global or national regulatory standards governing the intermediation process, the innovation and use of US collateralised debt obligations allowed local subprime mortgages to be repackaged and sold globally in an integrated financial system.
Governance of the global financial system at all spatial scales must work together to coordinate and collaborate Axelrod, , because no level of governance is sufficient as an island of regulatory control. The high degree of integration and interconnectedness across the financial system calls not only for vertical regulation, but also horizontal regulation that looks between and across all spatial silos of governance.
Lesson 3: Rapid technological innovations enable systemic complexity and overwhelm regulation.
This was facilitated by new technologies, which underpinned an escalation in system traffic and complexity, which was not understood by the users of the system. Technological change via the acceleration of computer processing has greatly contributed to system fragility because microprocessors facilitate logistical chains, increase connectivity and facilitate the innovation of complex financial instruments, the underlying mathematical theories of which can be flawed, hard to understand and even more difficult to regulate Colander et al.
In retrospect, it is not surprising that both the traders and regulators had a poor understanding of the systemic risks of new financial instruments. This was demonstrated in the financial crisis when the average path length of the financial network had decreased to fewer than 1.
Above all, these financial instruments contributed to the financial crisis because their rapid innovation outpaced the understanding of regulators and institutional responses. The fourth lesson emerges from new pressures and homogeneity in management incentives.
The financial crisis demonstrated that deregulation and the advent of innovative new technologies led firms to mimic one another and become less diverse in the pursuit of investment return. What is less understood is the origin of this approach, which has been fundamentally driven by a shift in financial management theory.
In recent decades, inventory management strategy and international accounting standards shifted towards the notion that in an integrated global economy no assets should lie idle and every penny should be leveraged capital, as reported to the market in quarterly results Hutchins, This was evident in global financial systems leading up to the crisis, where excess liquidity or capital came to be regarded as a curse, so that innovative bankers sought ways to gain leverage even from capital reserved for regulatory purposes.
As Jervis explains , p. This lesson is important to other industries, including manufacturing and services, where the widespread squeezing of stocks and tightening of supply chains has also created new vulnerabilities and system fragility as resilience to shocks or breakages in logistics systems has been concomitantly reduced. This is a concern in both the private and public sectors and leads, for example, to hospitals reducing their stocks of oxygen and other vital products. Lesson 5: Modern global financial institutions are inadequate in their response to systemic risk governance and cannot keep pace with innovation and increasing system complexity.
The international institutional framework for global finance is the best understood and most sophisticated of the global governance regimes Kerwer, The unpredicted collapse of the system has highlighted the vulnerability of even the most sophisticated institutions, as profound shortcomings in the governance system stemmed from a lack of understanding of systemic risk in the 21st century. Many of the greatest challenges of the 21st century are not new.
These include the elimination of poverty and disease, the avoidance of conflict and nuclear proliferation and the loss of biodiversity and natural resources. What is new is the nature of interdependence and complexity, as more integration and more people, combined with new technology, have led to increased interdependence and fragility and the creation of a global risk society. Faced with pandemics, security crises, threats of global terrorism and crime, climate change and many other looming threats, new approaches to global governance are required.
In the 21st century, the stakes for getting global governance right have never been so high or so urgent. The omens, however, are not good. If past decades provide a guide, new problems will be thrown at old and outdated institutions. Global finance is the best understood and most institutionally developed of the global governance regimes, yet these institutions failed to predict, prevent or understand the endemic systemic risks in the system, and they have yet to elicit the structural changes needed to manage proactively future systemic risks.
This is because in comparison to global finance, global institutions understand much less about other complex, interdependent and emerging systemic risks facing the 21st century. It is not surprising that these global institutions have suffered from a decline in legitimacy Stiglitz, , as they do not have the authority, the capacity or sufficient legitimacy to deliver on the enormous expectations placed on them, not least in systemic risk management. Although a reversal of the global economy may be possible, many of the other systemic risks in the 21st century are decidedly irreversible, complex and interdependent.
Global governance here will remain crucial. Many of these systemic risks will require global coordination and collaboration, as any action taken by one country, or even a few, is likely to prove ineffective Axelrod, As the number of both state and nonstate actors increases, so too will multiplicity of interests; collective action problems will surely be inevitable and contribute to systemic fragility.
A lack of political will has already been seen at the macro level, with the failure of international climate change agreements such as Kyoto, the inability to come to a global consensus on the regulation of weapons of mass destruction, and the ongoing international debate on stem cell research Martin, Despite these enormous challenges, because global governance is necessary in the 21st century, global policy reform is needed to improve it and to ensure that economic globalisation is maintained in the future Stiglitz, The majority of global governance reform has historically focused on more democratic governance in voting and representation Woods and Narlikar, While we recognise their importance, these reforms would not have predicted or resulted in better responses to the systemic risks that were triggered, amplified and propagated in the case of the financial crisis.
Reforms should not act as a substitute for the deep structural changes needed in global institutions to address the underlying forces that render the global community vulnerable to systemic risks. Recent decades have brought the greatest benefits history has known.
At the same time, globalisation, population and economic growth, as well as technological progress have created a world where growing interdependency and complexity have led to the emergence of new systemic risks. The financial crisis characterises the nature of a global systemic crisis in the 21st century. It has demonstrated that increasing linkages, technical innovation and management changes have increased both the robustness and fragility of the global financial network.
Systemic risks do not only plague global finance.