Can a Map Prevent the Next Financial Crisis?

President Barack Obama, left, flanked by Treas...

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The Network: How a map can prevent the next financial crisis

Source: Daniel Altman, The New Republic, October 9, 2009 | 12:00 am

The shock of the financial meltdown has had congressional committees scrambling for their gavels for the better part of a year. Politicians have been discussing how to make sure that such a near-cataclysm never happens again, and, for the most part, they’ve focused on the need for new regulation. What’s called for, President Obama said in March, is “a financial regulatory mechanism that prevents the kind of systemic risks that have done so much damage over the last several months.” But all the talk of regulation misses a key point: If we don’t know which institutions are doing what–if we don’t actually monitor what we’ve regulated–then that regulation won’t work.

The new tools that researchers now envision are meant to foresee crises in financial systems that have become impossibly complicated. “You want to see the build-up to a crash,” Markus Brunnermeier, a professor of economics at Princeton, told me in a recent interview. “You want to see it coming on.” Brunnermeier has met with Treasury SecretaryTimothy Geithner on several occasions and has collaborated with researchers at the Federal Reserve Bank of New York, the chief implementer of American monetary policy. Brunnermeier’s method for seeing it coming would begin with the data that the Fed already collects. Every quarter, 26 big bank holding companies report a number to the Fed called “value-at-risk,” which is an estimate of the maximum money they might lose in the near future with a given probability. But, while banks can calculate their own value-at-risk, they can only guess how stable other banks are–which makes them vulnerable to the ill fortunes of those with whom they share thousands of financial ties. This is where Brunnermeier had his insight: What if I knew the relationship between one bank’s value-at-risk and the value-at-risk of the entire industry?

Another pair of researchers is working along similar lines at Sandia National Laboratories, a government research installation in Albuquerque, New Mexico, concerned primarily with nuclear safety and national security. Until 2001, Robert Glass had been studying highly mathematical topics like how fluid flows through porous materials and the patterns that form in air turbulence. In 2004, he and Walter Beyeler, an expert on the disposal of nuclear waste, turned their modeling skills to two crucial pieces of American infrastructure: the power grid and the payments system that is the backbone of our financial architecture. Beyeler and Glass started creating network maps of the payments system, and, not by coincidence, they looked a lot like the maps Lo described. “The basic idea is that a small number of the nodes in the network have a very large number of connections, and there’s a very large number of nodes in the system that have one or two connections,” Beyeler says. In such a map, Lehman would have shown up as a node connected in myriad ways to scores of other nodes, including virtually all of the other big financial institutions. In other words, it would have been a critical hub whose disappearance would cause ripples throughout the system. …

For full text of this article, click here.

For example, Beyeler et al., 2007. Congestion and Cascades in Payment Systems or Soromaki et al., 2007, the Topology of Interbank Payment Flows For a published version of this report, see Walter E. Beyeler, Robert J. Glass, Morten Bech, and Kimmo Soramäki, “Congestion and Cascades in Payment Systems,” Physica A: Statistical Mechanics and Its Applications 384, no. 2 (October 2007): 693-718. And, see Kimmo Soramäki, Morten L. Bech, Jeffrey Arnold, Robert J. Glass, and Walter E. Beyeler, “The Topology of Interbank Payment Flows,” Physica A: Statistical Mechanics and Its Applications 379, no. 1 (June 2007): 317-33.

See also previous post on geocoding the Home Mortgage Disclosure Act.

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