Interconnectivity of economic risk: Our global financial system as a living organism
11 November 2014
When evaluating financial risk it is important to take into account how connected all the moving parts within our global financial system are.
While many institutions operate autonomously in their markets, it is impossible to function completely independently of the larger system; the international system is like a living and breathing organism. Few truly understand how it works, but the fundamental processes that drive it occasionally collapse in financial crisis that affects everyone.
Exploring the interconnectivity of the international financial system is analogous to William Harvey’s study of the human cardiovascular system in 1682. By mapping the human circulatory system, Harvey revealed the interconnectedness of the whole body, revolutionising entirely the studies of physiology, medical science and healthcare. An occurrence in one part of the body can affect another, akin to how a financial event in one part of the global system can have a major effect on the whole system.
For example, during the 2008 credit crunch we saw a highly aggressive financial contagion that originated from one point and proliferated throughout the system in a massively surprising way; many described the financial system as having had a heart attack. Institutions did not realise their interconnectivities, so the rapid domino-effect came as a shock. Since then, regulators and practitioners have developed techniques to analyse the interconnectivity of the financial system and developed regulatory frameworks to prevent the propagation of crises in the future.
However, as interconnectivity continues to deepen around the world, it is crucial that risk managers and macroeconomic planners understand the potential severity of possible future downturns, especially the “tail” events of economic catastrophe. A new discipline of research into financial risk management has emerged using network theory to help with this.
The studies aim to identify and analyse all possible connections between financial institutions and help to visualise and explain what our financial systems look like to risk managers; the emerging anatomical map of these systems lays the foundation for organisations to monitor the global financial heartbeat and understand and defend themselves – and the rest of the organism – against possible financial catastrophe.
RMS is also driving research on how catastrophe-modelling methodologies can be applied to model financial risk contagion, and supports the Cambridge Centre for Risk Studies, which has just assisted in the launch of a new Journal of Network Theory in Finance, which compiles the key papers of financial risk studies worldwide to provide a balanced view of how network theory in finance can be applied to business.
A better understanding of the interconnectivity of financial risk empowers risk managers to protect themselves and their clients against future financial heart attacks, something that will benefit the entire world.
Andrew Coburn is senior vice president, RMS
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