Financial Networks and Contagion

"Financial Networks and Contagion," a recent paper by Matthew Elliott, Benjamin Golub, and Matthew Jackson, uses network theory to study how financial interdependencies among governments, central banks, investment banks, and other institutions can lead to cascading defaults and failures.

Source: Elliott et al. 2013

While the model is quite technical, the main theoretical findings are fairly intuitive. They define two key concepts, integration and diversification. Integration refers to the level of exposure of institutions to each other through cross-holdings. Diversification refers to how spread-out the cross-holdings are; in other words, whether a typical organization is held by many others or just a few. The key finding is that at very low or very high levels of integration and diversification there is lower risk of far-reaching cascades of financial failures. The risk of a far-reaching cascade is highest at intermediate levels of integration and diversification. The authors explain:

"If there is no integration then clearly there cannot be any contagion. As integration increases, the exposure of organizations to each other increases and so contagions become possible. Thus, on a basic level increasing integration leads to increased exposure which tends to increase the probability and extent of contagions. The countervailing effect here is that an organization's dependence on its own primitive assets decreases as it becomes integrated. Thus, although integration can increase the likelihood of a cascade once an initial failure occurs, it can also decrease the likelihood of that first failure... 

With low levels of diversification, organizations can be very sensitive to particular others, but the network of interdependencies is disconnected and overall cascades are limited in extent. As diversification increases, a "sweet spot" is hit where organizations have enough of their cross-holdings concentrated in particular other organizations so that a cascade can occur, and yet the network of cross-holdings is connected enough for the contagion to be far-reaching. Finally, as diversification is further increased, organizations' portfolios are sufficiently diversified so that they become insensitive to any particular organization's failure."

Near the end of the paper, they illustrate the model using cross-holdings of debt among six European countries. The figure above is their representation of financial interdependencies in Europe. They conduct something akin to stress tests, simulating cascades of failures under various scenarios that very roughly approximate conditions in 2008. The simulations find that, following a first failure in Greece, Portugal is fails from contagion. After Portugal fails, Spain fails due to its large exposure to Portugal. The high exposure of France and Germany to Spain causes them to fail next in most simulations. Italy is always last to fail due to its low exposure to others' debt. They emphasize that this is intended only as an illustrative exercise at this stage, but could eventually be refined and incorporated into analysis of failure and contagion risk.

*Edited to fix my mistake pointed out by Phil.

Diversity in Economics

Bank of England Governor Mark Carney, in an interview earlier this month, pointed out that there are no women on the Monetary Policy Committee (MPC). There also happen to be no female ministers in the Treasury. Carney suggested,

“What we have to do at the Bank of England is grow top female economists all the way through the ranks. That adds to the diversity in macroeconomic thinking, it adds to qualified candidates for the MPC including qualified candidates to be a future governor.” 

This seems like a reasonable message, but Philip Booth at the Institute of Economic Affairs wonders "why Osborne and Cameron are not hauling Carney in for a dressing down." He makes a deeply confusing comparison between Carney and Larry Summers, and then adds:

"It is worth noting that I am quite comfortable with the idea that the sexes are complementary and that, in any business, social or family situation, they may (on average) bring different characteristics to the table. However, if Carney holds this position, there are some interesting conclusions because, if it is accepted that women (on average) might exhibit certain skills in greater preponderance than men, then the opposite may have to be accepted too. But, let’s move on…"

Before moving on, though, what are these "interesting" conclusions? If men do exhibit certain skills (like passive-aggressive ellipses usage) in greater preponderance than women, do we really know that each of these man-skills are beneficial for monetary policymaking? 

Booth writes, "Surely, there can only be two reasons [for Carney's remarks] – that Carney believes that there are intrinsic differences between the ways in which men and women reason and assess evidence or that their social experiences are different from those of men who have similar career patterns."

Really, can these be the only two reasons? Isn't it also plausible that Carney thinks the lack of women on the MPC is a sign that some qualified candidates are, for various and perhaps subtle reasons, not making it into or up the ranks, and that excluding part of a talent pool is a generally bad idea? It is not just that the social experiences are different for men and women who have similar career patterns-- different social experiences also lead men and women to having different career patterns. Does Booth himself think that it is just a big coincidence that there are zero women out of nine on the committee? Surely his manly math skills are good enough that he doesn't chalk that up to random chance. So even though Booth is chiding Carney for implying that men and women are intrinsically different, he seems to be working off of some "interesting" assumptions himself.

Next, Booth manages to list eight female economists, but doesn't personally think that any of them would add diversity to the MPC. He thinks Gillian Tett might add diversity to the group, "but it is the fact that she is an anthropologist that ensures that her views add diversity, not the fact that she is a woman." (In fact, a survey of 400 economists documents notable differences of opinion between the genders.) Then he gets to the most telling paragraph:

"It does not follow that adding those women who choose to become economists to a group of male economists adds to the diversity of thinking of the group of economists. It may be the case...that those women who ‘add diversity’ in intellectual life do not choose to become economists. This would mean that women contribute to diversity in society but not necessarily to diversity amongst economists."

He is inadvertently proving Carney's point, just as he is trying to tear it down. If he thinks that intellectually diverse women do not choose to become economists, he needs to ask himself why that is. It might help to read Neil Irwin's article about what happens when a certain female economist does "contribute to diversity":

Yellen has a perfectly solid relationship with Bernanke, as best as I can tell, but she’s more of her own thinker within the institution. She has spent her time as vice chairwoman urging Bernanke and her other fellow policymakers to shift policy to try to do more to combat unemployment, and thinking through ways to do just that...And people dealing with her within the Fed have viewed her not so much as Bernanke’s emissary but as her own intellectual force within the organization.

Felix Salmon summarizes Irwin's reasons why the White House is uneasy about Yellen:

"The first is the 'team player' attack: Yellen is an independent thinker more than she is a loyal deputy to Bernanke... She never became part of the boys’ club which was making enormous decisions on a daily basis in the fall of 2008... The 'team player' argument, then, is basically the 'one of us' argument, thinly disguised. Which is the first place that the sexism comes in...
This second reason essentially takes the 'team player' argument past its breaking point, to the point at which the Obama team is basically saying 'Yellen needs to share our biggest weaknesses.'"

I hope this post was not too much of a rant. I just wanted to make the point that Governor Carney's remarks are perfectly acceptable and in fact welcome.

Possible Futures for the European Banking Union

In September 2012, the European Commission proposed a single supervisory mechanism (SSM) for banks as a preliminary step towards a European banking union. Plans for the union continue this week, as European Union leaders meet in Brussels to set new rules regarding how future bank bailouts will be paid for.

 Earlier this year, I attended the Future of the Euro Conference at UC Berkeley. One of the conference panels was about banking unions. The panelists all draw upon economic history to discuss the possible future of a European banking union. Here are videos of their talks:   

Finance and Morality

A few weeks ago I wrote about Ignazio Visco, Governor of the Bank of Italy, and his lecture on the Financial Sector After the Crisis. This week he gave the opening remarks at the Islamic Financial Services Board forum on "The European Challenge."

The main prescriptions relating to financial transactions in accordance with Islamic religious law are the ban on paying interest and the prohibition of excessive uncertainty and speculation in contractual arrangements. This is predicated on the principle that profits should be generated from fully sharing in the business risk of an investment (the so called “profit and loss sharing principle”). The asset-backing requirement complements these prescriptions, providing for the link between each financial transaction and an identifiable underlying asset. 

A few weeks ago I gave a lecture on the financial sector after the crisis. On that occasion, it occurred to me that the renowned economist and philosopher – and eventually Nobel laureate – Amartya Sen had given in these same rooms the first of our scholarly lectures entitled to the memory of our late governor Paolo Baffi. Sen’s lecture was on “Money and Value: on the Ethics and Economics of Finance”. It is of course an interesting and good read in these difficult days. But what I was most intrigued by was Sen’s question: “How is it possible that an activity that is so useful has been viewed as morally so dubious?” 

There are indeed a good finance and a bad finance. While we may have some differences in ideas and perceptions on the goods and the bads, I think that what is most important is really to focus on the link between financial transactions and underlying assets, to conclude, with Sen, that “finance plays an important part in the prosperity and well-being of nations”. Indeed, it is crucial for sharing and allocating risk, especially for poorer societies and people. It is crucial for transferring resources over time and removing liquidity constraints. It is very important for fostering innovation and promoting economic growth. 

But it has to be certainly “ethical” and certainly transparent.

Many religious traditions have long recognized the moral and ethical challenges of finance and provide at least some guidance to their followers on the issue of finance. Ignazio Visco is not himself Muslim (as far as I know), but he is sympathetic with some of the moral sentiment behind Islamic religious law about finance. What I think we are seeing recently, and will see more of, as a result of the financial crisis is a wider-spread emphasis on morality in finance.

Not that this is entirely new. Via Nathan Tankus, here's a quote from The Economist, November 2, 1907 (after a major banking panic):

The financial crisis in America is really a moral crisis, caused by the series of proofs which the American public has received that the leading financiers who control banks, trust companies, and industrial corporations are often imprudent, and not seldom dishonest. They have mismanaged trust funds, and used them freely for speculative purposes. Hence the alarm of depositors, and a general collapse of credit.

What can a secular society do about a moral crisis? Can regulatory reform (like Admati and Hellwig's proposals in "The Bankers' New Clothes," for example) make the financial system as a whole more "moral" seeming, even if individuals within the system are not moral? Can economists treat morality as something that can be incentivized? I need to keep this post brief today since I am preparing for a presentation tomorrow, but I'd love to hear readers' thoughts on these questions, or for people to post links to good readings on this topic.