What can Mother Nature teach us about managing financial systems?
Like ecosystems, financial markets are complex evolving systems from which unexpected bubbles, crashes, and other surprising behaviors can emerge. Building resilient financial systems may require policymakers to take cues from biology.
During a half-hour interval on May 6, 2010, stock prices for some of the largest companies in the world dropped precipitously, some to just pennies a share. Then, just as suddenly and inexplicably, shares recovered to their pre-crash prices.
This unprecedented event, burned into the memories of investors and regulators alike, is now known as the Flash Crash. Since that day, financial markets have seen flash crashes in US Treasury securities, foreign currencies, and exchange-traded funds (ETFs). Other puzzling, system-wide glitches are becoming more frequent as well.
Without a doubt, our financial systems are complex and often unpredictable, and when they swing out of control they remind us how much we still have to learn about how they work and how inadequate our traditional methods of controlling them are.
In all their complexity, though, financial markets don’t hold a candle to the natural world, with its 8 million-plus species – those we know of, not including the millions that have come and gone – interacting and evolving in the world’s forests and oceans and in the microbiomes of our guts.
In the century and a half since Charles Darwin published On the Origin of Species, we still are stymied by the complexity of the biosphere; and, just as with our financial systems, our efforts to intervene have often led to confounding results.
Smokey the Bear offers an example. For seven-plus decades, this popular icon has reminded us of the importance of preventing wildfires. But modern ecological practice recognizes that suppression of all forest fires today simply sets up forests for larger and more destructive catastrophes tomorrow. In all likelihood, financial systems are no different; small catastrophes are probably essential in maintaining their ongoing health.
But how? How might biology inform our efforts to manage markets? How can we get beyond a metaphorical understanding of the ways markets and ecosystems are alike to explore, in practical terms, what our scientific theory offers our financial regulatory apparatus?
Earlier this year, during a Santa Fe Institute-sponsored meeting at the Keck Center of the National Academy of Sciences in Washington, D.C., we pulled together experts from economists to ecologists to evolutionary biologists. We called the meeting “New Approaches to Financial Regulation.” Our intent was to find common theoretical grounds with which to inform future financial regulatory approaches.
The complex systems perspective
The biosphere and the “financiosphere” are both dazzling in their complexity, with striking similarities. Both are dynamic systems in which the selfish actions of countless individuals – whether they be cells or investors – lead to unpredictable consequences at the system level. In turn, these collective actions and consequences feed back to influence individual actions in endless cycles of adaptation and evolution.
This adaptive cycle is the essence of a complex system. It’s also what makes complex systems difficult to understand, hard to predict, and tricky to manage.
Not surprisingly, in both the biosphere and financial markets, the resulting system-level emergent phenomena include unexpected crises and collapses, from population crashes to stock devaluations, from the desertification of lush landscapes to market failures, from the disappearance of species to the demise of industries.
But biological systems also exhibit remarkable resilience. By studying how evolution has made them more robust, might we develop new and wiser approaches to financial regulation? We think so.
Exploration and exploitation
Life began on this planet nearly 4 billion years ago, and despite frequent insults and challenges, we are still here (at least for the moment). We know that life’s remarkable robustness, in large part, is dependent on variation; systems that suppress or lose their diversity are prone to collapse.
Through continuous innovation, via mutation and sexual recombination, for example, coupled with a seemingly simple filter called natural selection, which leads to the fittest innovations surviving to reproduce, life responds and adapts to changing environments and to itself. Charles Darwin, impressed by the “tangled bank” that emerged from these evolutionary dynamics, revolutionized our understanding of the world about us, and his insights are still with us.
But natural selection’s apparent simplicity turns out to be deceptively complicated. Even the mechanisms of evolution, including those that generate innovation in the form of new variants, are subject to constant modification. Mutation rates (the rapidity at which genetic variants occur) are subject to selection pressures (influences that suppress a population’s reproductive success). Even sexual reproduction itself has evolved to provide a greater variety of genetic material on which natural selection can act.
This interplay between exploration, by which new solutions are tested, and exploitation, by which the best solutions are multiplied and spread, is characteristic not only of evolution via natural selection, but also of the way people, companies, and other institutions must allocate their time and effort to survive and thrive in an economy – which is to say that business and markets are shaped by many of the same evolutionary processes that shape the natural world.
Evolving for the unknown
Importantly, evolution is not about optimization in the abstract; it is about optimization relative to other genetic variants within and across species. While we are evolving, so too are our enemies (like the influenza virus) and our friends (including the microbiomes in our guts). To a large extent, evolution is about preparing for the unknown, because the scope of possible changes in our environments is so immense that we cannot hope to predict their form or timing.
We can predict, however, that during our lives, we will be assaulted by a variety of pathogens. Thus, vertebrates have evolved a contingency plan in the form of immune systems and barriers to invasion, such as skin and cell membranes. These systems combine early warning indicators and generalized first lines of defense that buy time while we populate our immune repertoire with more specialized antibodies tuned to the specific threats. This is akin to circuit breakers in financial securities markets, which shut down trading when volatility is too high.
At the same time, mammals have evolved regulatory systems that help maintain the stability of our systems. Human heart rate and breathing, for example, are regulated by physiological processes that correct deviations from the norm in the time scales required for survival – kicking them into overdrive when we’re being chased by a tiger, for example.
But when our physiological feedback loops are too weak or too slow, or too strong, pathologies arise.
Regulatory feedbacks that are “just right” help maintain a healthy human.
Similarly, when the time scale of financial innovation outstrips that of regulation – as in the case of high-frequency trading – there are likely to be unintended consequences. But regulatory responses that are too strong or poorly timed – like emergency price controls, short sales restrictions, bank holidays, and extreme capital constraints – can lead to greater panic and uncertainty among investors and consumers, ultimately causing even less desirable outcomes such as housing market crashes, rapid inflation, and recessions.
Regulatory feedbacks that are “just right” help maintain a healthy economy.
These complex interrelationships underscore the importance of maintaining diversity in financial markets, in part by allowing enough exploration (that is, financial innovation) to produce the requisite diversity for a healthy system. But what is the right amount?
As mentioned earlier, evolution has dealt with the diversity problem in part by regulating evolutionary processes themselves: the rate at which mutations occur, and sexual recombination, which helps ensure a reassortment of the genes in a population and the production of new variants.
We tend to think of evolutionary change primarily in terms of natural selection based on the reproductive success of individuals with helpful traits. But all complex systems, including biological systems and business ecosystems, also exhibit self-organized patterns at scales larger than at the level of individuals. Such self-organization also “selects” by producing, from the interactions of individuals, emergent features that themselves either persist or wane. The self-organized systems that persist, and that we observe, tend to have properties that make them more robust.
Such self-organization does not always lead to robust systems, however; self-organized phenomena may also contain the seeds of system collapse, as we saw in the financial crisis of 2008–2009, when financial innovation and unprecedented connectedness, among other factors, combined to bring the system to the brink of failure.
Still, some features of biological systems might be helpful in designing self-organized financial systems for robustness.
Redundancy provides insurance against loss. The American chestnut largely disappeared from the forests of the Northeastern United States, but other species filled its niche. In 2004, though, when Chiron, one of only two companies providing flu vaccines in the US, announced that its plants in Liverpool were contaminated, our house of cards was at real risk of collapse. We were too dependent on too few suppliers.
Modularity (the inverse of connectedness) isolates related elements, limiting systemic risk by reducing the potential for a local problem to spread globally. Quarantines and barriers restrict movement of infected individuals to help control the spread of a contagion. Such methods are used not only for human diseases, but for livestock, as in the case of foot and mouth disease. Likewise, modularity in financial systems can help keep problems that emerge in one market or industry from spreading to others and pulling the whole system down.
In biology, breakdowns in size regulation, such as with gigantism, are considered unhealthy for biological organisms. Likewise, the unchecked growth of financial institutions can lead to banks that are “too big to fail,” which, we now understand clearly, can threaten global financial stability.
Cues from evolution
Any view of financial systems must recognize that they are ecosystems, linking agents, stocks, and flows. Just as an ecosystem ecologist is focused on the cycling of crucial elements like carbon, nitrogen, and phosphorus, so too might a “financial ecologist” focus on the sustainable cycling of crucial elements like capital, labor, and financial innovation.
As we refine and define the levers by which we attempt to manage tomorrow’s economies, we must keep in mind that regulations that focus on specific parts of systems often miss the big picture. In the build-up to the 2008 crisis, for example, bank regulators naturally focused on the banking industry, neglecting the impact of the rapidly emerging shadow-banking system and its impact on financial stability.
Management of ecological systems in the past has often opted for narrowly derived or simplistic interventions, but the ensuing failures have led to calls for ecosystem approaches – in the management of fisheries and forests, for example. Similarly, our failures to predict and control financial ecologies should remind us that, if anything, the interconnectedness of global financial systems is ever greater, and a holistic approach is essential if we are to succeed.
As adaptive complex systems, natural and financial systems share deep likenesses. We should take cues from billions of years of evolution. Nature, and biology, offer solutions to a number of challenges of financial regulation, not to mention the regulation and control of many other systems crucial to well-functioning societies.
Simon A. Levin is the James S. McDonnell Distinguished University Professor in Ecology and Evolutionary Biology at Princeton University, and author of Fragile Dominion: Complexity and the Commons. His research focuses on how ecological, behavioral, and evolutionary mechanisms that operate primarily at the organism level lead to macroscopic patterns and processes at the ecosystem and biosphere levels. More recently he has turned his attention to the parallels between ecological and economic systems, in particular the evolution and development of their structure and organization and what makes them vulnerable to collapse.
Andrew W. Lo is the Charles E. and Susan T. Harris Professor of finance at the MIT Sloan School of Management, director of MIT's Laboratory for Financial Engineering, and coauthor of The Econometrics of Financial Markets and Hedge Funds: An Analytic Perspective, among others. His research interests include financial asset pricing models; financial engineering and risk management; trading technology and market microstructure; and, more recently, evolutionary and neurobiological models of individual risk preferences and financial markets.