Figuring out why financial crises emerge in seemingly stable economies is tough. Widespread collapses are notoriously difficult to predict - to do so requires a comprehensive view of a complex, interconnected system. But help may be at hand: experts in finance are now looking to certain fields of ecology to help provide this viewpoint.
Ecologists have long been concerned with how connections between species relate to the overall stability of an ecosystem. Rather than focus on an individual species, some use a powerful branch of mathematics called network theory to map out a web of interaction. These networks can then be compared to one another to provide insights into how an ecosystem might cope with external shocks. Depending on the network’s structure, even a small change can threaten an entire system.
For example, in the 1940’s a drought-resistant plant native to Africa and Asia known as Buffelgrass was introduced to the south-west America’s Sonoran Desert as a means of feeding cattle. Although the hardy grass initially seemed benign, it soon began displacing native species of flowering cacti. This triggered a destructive feedback loop: as populations of pollinators (such as the Rufous Hummingbird) began to suffer, damage to the flowering cacti accelerated. Within a few decades, these harmful impacts had spread and multiplied over a broader network of pollinators and plants.
This snowballing cycle can be seen in financial crises as well. Should a bank go insolvent and jettison its assets, the price shock can tip other organisations into bankruptcy as well. This cascade of bank failures can draw in more financial institutions and assets, rapidly multiplying and deepening the impact of the financial crisis.
So how can one prevent such catastrophic cycles? The fragility of these systems emerges not from the weakness of any one individual species or bank, but rather due to the nature of the system as a whole. These “systemic risks” have been the subject of much research in recent years, and ecological insights may provide clues into how to protect our economies.
As it turns out, banks might look to bees and flowers. Pollination networks have been studied in depth, and researchers have identified two key structures that can maintain stability: “nestedness” and “modularity.”
In a nested network, a specialist with few connections will be connected to a generalist that has many connections, including the all the ones the specialist has. For example, if a specialist plant relies on only one species of insect to pollinate it, the generalist insect will rely on many different types of plants. This ensures that the insect species will probably survive a shock to any one plant, in turn increasing the safety of the specialist plant. Specialists relying solely on other specialists could set up a precarious line of dominos.
A [modular network](http://en.wikipedia.org/wiki/Modularity_(networks) is one that provides some degree of isolation between distinct groups. If every species is connected to every other species, substantial damage can easily propagate throughout the entire network. But in a network with high modularity, disturbances are typically quarantined, allowing the rest of the ecosystem to continue relatively undisturbed.
Whether or not financial networks could fully adopt these nested or modular structures remains a topic for debate. Some patterns of interaction between individuals, businesses, banks and government will be tough to shift.
Prominent ecologists such as Robert May who have explicitly examined the banking system make a strong case for change. May and his colleagues note that all banks have an incentive to diversify their assets. However, diversity between banks can paradoxically diminish as they all pursue similar diversification strategies.
While individual banks are far less likely to fail with diversified holdings, the system as a whole becomes vulnerable to total collapse via these asset-holding connections.
What works as a risk-reduction strategy for each individual bank actually makes the system as a whole more fragile. As May and Arinaminpathy point out, “we have, in effect, what evolutionary biologists would call the Prisoner’s Dilemma or ecologists the Tragedy of the Commons.” Such a dynamic could make it significantly harder to reduce the risk of another financial meltdown in the future.