11 July 2013

Gillian Tett: Dense feedback loops heighten risk of contagion

The word “feedback loop” has been sowing fear ever since the 2008 crisis showed how interconnected the modern financial system has become. And with trading liquidity having shrivelled in recent months – and volatility having risen – the issues of contagion and feedback loops are raising unease again. But while that “C” word – contagion – provokes alarm, what is also striking is just how little we understand the complex network of modern financial flows.

Of course, much economic research has been produced since 2008 analysing how asset classes, or individual countries – or continents – are performing. But if you compare the field of financial economics to the hard sciences, there is still surprisingly little “joined up” analysis of finance as a single interconnected entity.

A large team of American and Italian economists – including luminaries such as MIT’s Robert Merton and Andrew Lo, and the International Monetary Fund’s Dale Gray – are trying to fill this gap, not by tracking opaque financial flows, but by looking at a proxy signal of connectivity, namely credit derivative prices. In particular, last year the team analysed how credit default swap prices have moved for a wide range of US and European banks, insurance companies and sovereign entities. They then plotted the links between different institutions and geographical areas into a unified map, to show the density of interconnections, modelled over the past decade.

Two thought-provoking points have emerged from these “maps”.

First, it seems there is a discrepancy between levels of connectivity and contagion risk across the western world. As of March 2012, this mapping exercise indicated that US financial entities had only moderate levels of connectivity with European sovereign or private sector entities; when conditions deteriorated in the eurozone, US banks were not badly hit in the CDS world. Italian entities, by contrast, seemed very vulnerable to contagion anywhere else in the world; so were Greek banks and insurance companies.

But another intriguing point raised by these maps is that interconnections change over time. Most notably, when the economists created a map of the financial links between 2009 and 2012, they found that the pattern looked far denser than between 2004 and 2007. This may be because of consolidation in the financial industry.

If there had been better “maps” of eurozone finance publicly available earlier this year, perhaps those Cypriot banking woes would not have come as such a surprise; or, at least, policy-makers and investors would have had less excuse to ignore the challenges associated with living in an interconnected world. It is a salutary tale indeed.

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