By Pallab Ghosh Science correspondent, BBC News
Regulators in financial markets could learn from nature, says the report.The risk of financial meltdown is underestimated in the regulation of banks, according to a study.Researchers say that regulators could learn from complex networks that exist in nature.
Co-author Andy Haldane said: "in financial ecosystems evolutionary forces have often been survival of the fattest rather than the fittest" because of government support. Details of the research are published in the journal Nature.
According to Mr Haldane, who is the Bank of England's Executive Director of Financial Stability, financial models can be improved by studying how they operate in more detail. The first step, he says, is to gather data on how different elements interact. "In October 2008, the financial system, and world economy, fell off a cliff," he told BBC News. "Conventional economic models struggled to make sense of that. But such cliff edges and tipping points are commonplace in networks, from infectious diseases to power grids, from forest fires to the world wide web.
"The dynamics of these systems would help in developing economic models which make sense of the contagious consequences of Lehmans Brothers' failure".Mr Haldane reviewed scientific literature with the renowned epidemiologist and former government chief scientist, Lord May of the University of Oxford. They compared the dynamics of financial interactions with other complex networks such as ecological food webs and the spread of diseases.
“In finance it's often been survival of the fattest rather than the fittest”Andy Haldane Bank of England
Lord May told BBC News that natural ecosystems are "survivors over half a billion years of evolution whereas the banking system has no such pedigree and it's governed mainly by interactions with regulators and government". "A lot of the mathematics that underpins derivatives and credit default swaps rests on often implicit assumptions on things that are like a balance of nature, 'global equilibrium'. (But these) should be looked at in an analytical way rather than appealing to vague concepts such as perfect markets," he said.
Haldane and May cite research which suggests that the conceptual underpinning of how derivatives are priced is "invalid". Derivatives are financial instruments with values based on the predicted future movements of a share or currency.The studies show that the more complex such schemes are, the more unstable they become.
Professor May commented: "When things do go pear shaped how do you stop it propagating right through the system?" He said he worries that that regulation has been set to reduce the risk to individual institutions but it may have increased the risk to the system as a whole.“Big banks should hold bigger reserves because they are more important in the context of the system,” Lord May Oxford University
In recent years there has been a trend for bigger banks to hold smaller capital reserves - which according to May and Haldane has made the financial system as a whole more vulnerable. "You would rather be inclined when looking at the propagation of risk to suggest that the relatively big banks hold relatively bigger reserves because they are more important in the context of the system," according to Lord May. In other words, if they fail everyone else fails. So May and Haldane say there should be more liquidity in the system - particularly for bigger banks. Liquidity is the ability of an asset to be bought or sold in a market without affecting the asset's price.
In the boom years, banks tend to run down their liquidity to make most use of their capital. And in bad times, they are building up liquidity as insurance. This results in less money being loaned to small businesses to keep them running.
Lord May commented: "In boom times when people are taking bigger risks you ought to hold bigger capital reserves and in bust times, when one of the priorities is to free up the money supply, you ought to hold smaller capital reserves."