Our Financial System Resilience Index, based on insights from complexity science, reveals that the UK’s resilience declined dramatically in the 2000s to levels far below those of other leading industrial economies. Despite some marginal improvements since the crisis of 2008, without major structural changes our financial system remains at risk of future crisis.

The 2008 crisis underlined a series of weaknesses in the global financial system. Efforts to redesign and regulate the system must focus on ensuring resilience – the system’s ability to continue to serve the economy well in the face of shocks that unfold suddenly from within, as in 2008, and also gradually emerging strains on the system, such as climate change.

While policymakers and regulators do talk about resilience, it is not always clear what they mean. Often it is implicitly assumed that, by making individual banks hold more capital, we can stop them from ever going bust – ‘resilient’ banks will equal a resilient system. This is a dangerous assumption; it also ignores our growing understanding that complex systems are about much more than the sum of their individual parts.
Drawing on academic and policy literature and a series of expert interviews and roundtables, we find seven key factors that influence system resilience and that can be measured:

  1. Diversity – healthy systems have a diversity of actors who occupy a variety of different niches in the system and employ different strategies to thrive.
  2. Interconnectedness and network structure – the way financial institutions are connected to each other affects the way a crisis spreads.
  3. Financial system size – financial systems that are large relative to their domestic economy pose a greater threat to economic stability.
  4. Asset composition – where banks invest matters, with some types of financial assets particularly prone to boom and bust.
  5. Liability composition – the way banks are funded also matters: short-term borrowing from other banks are more fickle and volatile than customer deposits.
  6. Complexity and transparency – the growing complexity associated with securitisation and the ‘slicing and dicing’ of loans can spread risks around the financial
  7. Leverage – the ratio between banks’ assets and their capital; this has been a key focus of post-crisis financial regulation.

Comparing national financial system resilience

We compiled numerical indicators for each of these factors to compare different countries’ financial systems, and whether they had become more or less resilient over time. This analysis finds that the UK economy has low levels of financial system resilience, significantly trailing other leading industrial economies, including Japan, Germany, France, Italy, and Canada.

Although the UK’s financial system resilience has improved slightly since the financial crisis, it remains the worst in terms of diversity, interconnectedness, financial system size, asset composition and complexity, and transparency. This has worrying implications for the UK’s economic stability.

Since the financial crisis, governments have focused on increasing competition between commercial banks and requiring banks to hold more capital. Our analysis finds that these may have limited effects on overall financial system resilience. Specific policy implications of the analysis include:

  • Competition policy must promote diversity, not simply more ‘lookalike’ challenger banks.
  • Policymakers cannot rely on complex new capital requirements to ensure system resilience: structural reforms, such as separating retail from investment banking, could be more effective.
  • The rise of peer-to-peer lending could significantly improve system resilience, but this depends on how the industry evolves.
  • A better knowledge of systems theory sheds light on vital characteristics of financial systems not currently reflected in policy, such as diversity, network structure, and the overall composition of banks’ lending.

We recommend that regulatory bodies:

  • explicitly define system resilience.
  • measure and publish resilience indicators.
  • apply multicriteria analysis to policy-making, including resilience indicators as criteria.
  • assess the resilience of the system as a separate and distinct exercise from assessing the resilience of individual financial institutions.
  • conduct further research on the impact of different network structures on financial systems performance and resilience.

It is vital that policymakers develop a more sophisticated understanding of resilience and use it to help reshape our financial system. Unless this is achieved, our economy and society remain at risk of a future financial crisis.

Image credit: remkovandokkum via Flickr