Blog

19
Sep

Biology as a Template For Financial Markets

Biological and ecological systems are full of complexity. So is the financial system. But here the similarity ends: for Nature and biology are complex in the right way, while the financial system is not.

The right way is diverse, symbiotic, adaptive and dynamically balanced. The wrong way is highly centralized, self-centered, disconnected, single-minded (profit seeking) and continually growing with concentrated pockets of risk.

In the right way we find a hierarchy of highly connected systems – systems within systems – that continually sustain one another. In the wrong way we find a hierarchy of isolated individuals committed to their own enrichment.

Looking deeper into living systems, we find an elegant simplicity in their structures that makes them uniquely resilient. The architecture of the human body, for example, is decentralized into a coordinated network, whose parts (cells, tissue, organs) resemble that of the whole (via DNA). The same is true in the fractal organization of Nature, where the design elements of trees and ecosystems are repeated in countless ways. This redundant architecture, which evolved over billions of years, enables Nature and humanity to recover from shocks that would destroy less adaptive systems.

Not so with today’s financial system. Its architecture is excessively centralized and unbalanced: dominated by a few “too big to fail” money center banks focused on quick returns rather than systemic stability.

As noted elsewhere on this blog, the ascendance of this quick return mentality runs in parallel with humanity’s ecological overstep: the accelerating depletion of earth resources that underpin our industrial economies. We see this ascendance most clearly in the astonishing rise of derivatives trading over the past 30 years from a small market focused on hedging risk to a global betting casino with roughly $1.2 to $1.4 quadrillion at play – amounts that represent roughly 17 to 20 times world GDP. (For more on this, see: www.dailyfinance.com/2010/06/09/risk-quadrillion-derivatives-market-gdp/)

“The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
– Warren Buffett, Berkshire Hathaway Annual Report 2002


Beyond the sheer volume of derivatives outstanding, we must be concerned about the concentration of risk in a small cadre of money center banks. According the US Office of Comptroller of Currency (OCC), the four US banks with the largest derivatives exposure – JPMorgan Chase, Citibank, Bank of America and Goldman Sachs – had a total of $212 trillion of derivatives outstanding on March 31, 2012. That is equivalent to 14 times US GDP or 3 times world GDP; and the real exposure is likely much higher because so many derivatives are not traded on official exchanges where they can be monitored.

In such a milieu, the failure of a significant counterparty – the person or institution on the other side of a derivatives trade – would result in a chain reaction of failures. We saw this in the 2008 bankruptcy of Lehman Brothers, which nearly caused a global financial meltdown. Today, the market risk is orders of magnitude bigger.

Given the extraordinary growth of the derivatives market relative to the global economy, it resembles a cancer more than a measure of financial health as banks would have us believe.

To global derivatives expert, Paul Wilmott, banks compound their risk by looking at markets as abstract systems that can be engineered by linear mathematical algorithms.

This attitude completely ignores the fact that markets are non-linear living systems – subsystems of humanity and the biosphere – whose behaviors are often highly unpredictable.

Because of this oversight, banks must continually manipulate their algorithms to match their data, which means their forecasting models are never correct.

“The minute you … recalibrate the model, you lose all possibility of tracking the error within the model. Why? Because when you calibrate, then your model matches the data. And then you come back a week later and you recalibrate again, and the model still matches the data. The problem is, you are recalibrating and changing the parameters and therefore the model was never correct.”
– Paul Wilmott: www.advancedtrading.com/quant/231901539


Returning to Balance

To achieve financial safety the banking system must mimic the modularity and redundancy of living systems so that bank failures, which are inevitable, don’t compromise the world’s financial infrastructure.

Banks can, and must, redesign themselves to resemble living systems – some already do – by becoming more decentralized and networked in structure and by shifting their focus towards systemic health rather than hyper-leveraged (hyper risky) financial gain. This transformation requires a radical cultural shift – dumping the prevailing norm of bonus-obsessed traders and dealmakers and returning to lending practices based on intimate knowledge of local economic needs. More subtly, it looks to build a corporate DNA of self-generating transformation through cultures of servant leadership, collaborative learning, systems thinking, transparency and inspiring corporate visions that place a premium on life – qualities that are discussed elsewhere on this blog.











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