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The Network

How a map can prevent the next financial crisis.

The shock of the financial meltdown has had congressional committees scrambling for their gavels for the better part of a year. Politicians have been discussing how to make sure that such a near-cataclysm never happens again, and, for the most part, they've focused on the need for new regulation. What's called for, President Obama said in March, is "a financial regulatory mechanism that prevents the kind of systemic risks that have done so much damage over the last several months."

But all the talk of regulation misses a key point: If we don't know which institutions are doing what--if we don't actually monitor what we've regulated--then that regulation won't work.

Indeed, signs of regulators' ignorance about what really goes on in the financial markets have been building up for years. Regulators got a warning in 1998, when a little-known hedge fund called Long-Term Capital Management (LTCM) suddenly faced collapse over a series of bad bets on emerging economies' debt. It wouldn't have made news, except that the little fund from Connecticut turned out to be holding 5 percent of the market where financial institutions traded risk with each other. In Washington, the heads of the major financial regulators were frantic.

"When LTCM came close to collapsing in the fall of 1998, that came as a great surprise to the Federal Reserve Bank of New York and to the Board of Governors, even though the counterparties to the contracts of LTCM were the big banks and the big investment banks," says a highly placed member of the Clinton administration.

Yet the authorities didn't learn. Two years later, the Commodity Futures Modernization Act, whose formulation was guided by a report signed by Alan Greenspan and Larry Summers, removed whole categories of so-called "over-the-counter" derivatives from oversight, allowing financial institutions to trade these securities in secret. It didn't take long to see what could happen: In 2001, the Enron debacle showed how a single company could use over-the-counter derivatives to accumulate billions of dollars in debt--unbeknownst to rating agencies and its own shareholders.

And still the laissez-faire attitude of regulators continued, even through the signal event of this crisis, the collapse of Lehman Brothers, when it became clear that the government simply hadn't understood the extent to which letting Lehman fail would tear the tightly knit fabric of the markets. The current crisis "probably was the result of inadequate information with too much financial innovation," says Malcolm Knight, a vice-chairman of Deutsche Bank who led the Bank for International Settlements, the bank of the world's central banks, from 2003 to 2008.

Nonetheless, it's possible that policymakers will still continue to miss the point. The solutions that lawmakers and some financial experts are now suggesting--like putting derivatives on markets rather than letting banks and other businesses trade them secretly--do not reveal all of the markets' internal workings, which is why some researchers believe the only way to handle the new economy is with stunningly new ways of collecting data about the global financial firmament, using all-seeing, all-knowing monitoring systems right out of Philip K. Dick's "The Minority Report."

The trouble, however, is that, even as these researchers race to finish their designs, skepticism is growing among the very industries that would be monitored by these systems, and by the regulators who might use them. A couple of years ago, this opposition might not have been surprising. Now that we know what's at risk, however, it is probably improvident, and possibly dangerous.

 

The new tools that researchers now envision are meant to foresee crises in financial systems that have become impossibly complicated. "You want to see the build-up to a crash," Markus Brunnermeier, a professor of economics at Princeton, told me in a recent interview. "You want to see it coming on." Brunnermeier has met with Treasury Secretary Timothy Geithner on several occasions and has collaborated with researchers at the Federal Reserve Bank of New York, the chief implementer of American monetary policy.

Brunnermeier's method for seeing it coming would begin with the data that the Fed already collects. Every quarter, 26 big bank holding companies report a number to the Fed called "value-at-risk," which is an estimate of the maximum money they might lose in the near future with a given probability. But, while banks can calculate their own value-at-risk, they can only guess how stable other banks are--which makes them vulnerable to the ill fortunes of those with whom they share thousands of financial ties.

This is where Brunnermeier had his insight: What if I knew the relationship between one bank's value-at-risk and the value-at-risk of the entire industry? Then I could see how one institution's problem spills over to other institutions, and I could focus on the institutions that seem to be at the source of these problems. The data, collected not only from banks but also from hedge funds and insurance companies, would have immediate implications for the firms' activities. If the data pointed toward a risk pocket during a crisis, the firms would have to stop taking on new risks and stockpile more cash. If groups of firms started to show similar vulnerabilities, computers and human supervisors would see these patterns, ideally before they got out of hand.

But, while Brunnermeier's solution would require collecting new data from thousands of firms, many of which currently report nothing to the Fed, some of his colleagues say his solution--looking at a few key numbers for each institution--does not go far enough. Andrew Lo, a professor and director of the Laboratory for Financial Engineering at the Massachusetts Institute of Technology, sees the global financial system as the universe, where each financial center is a galaxy: a collection of stars, planets and other celestial objects held close to each other by their own gravity--in this case, the trades and contracts that tie them together. If you could chart the entire universe and measure all the forces connecting every object inside it, you would have what economists and other scientists call a network map. To Lo, fully understanding what's going on in the markets requires the entire map--not just one value-at-risk number, but every major transaction that connects one entity to another, reported daily.

Another pair of researchers is working along similar lines at Sandia National Laboratories, a government research installation in Albuquerque, New Mexico, concerned primarily with nuclear safety and national security. Until 2001, Robert Glass had been studying highly mathematical topics like how fluid flows through porous materials and the patterns that form in air turbulence. In 2004, he and Walter Beyeler, an expert on the disposal of nuclear waste, turned their modeling skills to two crucial pieces of American infrastructure: the power grid and the payments system that is the backbone of our financial architecture.

Beyeler and Glass started creating network maps of the payments system, and, not by coincidence, they looked a lot like the maps Lo described. "The basic idea is that a small number of the nodes in the network have a very large number of connections, and there's a very large number of nodes in the system that have one or two connections," Beyeler says. In such a map, Lehman would have shown up as a node connected in myriad ways to scores of other nodes, including virtually all of the other big financial institutions. In other words, it would have been a critical hub whose disappearance would cause ripples throughout the system.

 

Mapping proposalshave received at least moral support from Democrats. "I think there is a lot of potential here--in fact, Andrew Lo has been talking to my staff," says Congressman Barney Frank, whose Financial Services Committee is slated to hear testimony on systemic risks in the next couple of weeks. "But we're not going to prescribe that; we're going to empower that. These are specifics that should be decided by the regulator, and not by Congress."

But even the regulators themselves are skeptical. "We're not the National Security Agency [with] total information awareness," says a senior official from the Federal Reserve Bank of New York who insisted on anonymity. "When you start to get to the type of information that would be required for the network maps, I think there would be a real reticence on the parts of the sovereigns and the institutions to provide that information."

So far, the financial industry's reaction has been to discount the feasibility and usefulness of network maps. Its trade group, the Institute of International Finance (IIF), decided to set up its own market monitoring group to "connect the dots" and "build a systemic picture" of the markets, yet it stopped short of recommending a network map.

"The practical and the concrete tools to have people do this are still being developed," says Hung Q. Tran, the IIF's senior director of capital markets and emerging market policy. "It's difficult in many instances to see how relevant information can be collected and made available to people at the right time."

The mappers' plans need to be more specific, too, said the Fed official. "There would be lots of different types of network maps," the official says. "There would be funding maps. There would be hedging maps for different types of market risk. Some of that we've been able to get further on, but I don't think we'd ever be able to get the full view of the market."

Yet, even if the United States balks, other countries may go ahead with network mapping. In February, Otmar Issing and Jan Krahnen, members of a commission advising the German government, wrote in the Financial Times that a global network map was "a vital element" for preventing future crises. And the main consultative document prepared for the European Union also recommended a map of global risks. But, without cooperation from the United States, any supposedly global map will be woefully incomplete. In the end, the question may be whether Washington is finally willing to stand up to the industry ... for its own sake.

Daniel Altman is president of North Yard Economics, a nonprofit consulting firm serving developing countries. He is writing a book on the future of the global economy.