Harnessing Network Science to Manage

Systemic Financial RiskJohn W. Bagby

Information Sciences & TechnologyThe Pennsylvania State University

Objectives Today• Ventilate this Working Paper

– Improve it; Strengthen its Weak Links

• Further Tie Securities Regulations to Financial Information Security – Major Source of Security Law – Systemic Financial Risk

• Use Law & Economics of Security to Design better Systemic Risk Remediation– WEIS 11th June 2012 in Berlin

• Recruit Network Scientists into Financial Info Security & Systemic Financial Risk Mgt.

Network Approach: Analyze the Book

For a Network Approach

• Systemic Financial Risk Imperils Economic Security

• Financial Crises Recurrence Requires Layered Financial Risk Management

• Analysis of Financial Interconnectivity Reveals Systemic Risks (the “Book”)

• Financial Market Integrity Requires Financial Information Security – Public Policies Prescription: Transparency of

Transactions & Fundamentals Reveals Systemic Interdependency Risk (again…the Book)

Systemic Risk vs. Systematic Risk

• Systematic Risk (Exogenous Factors)– a/k/a aggregate, market, undiversifiable– Exogenous Factor Impacts all Participants in

Entire Market• EX: interest rates, int’l tension, war, recession

– Managed thru Hedging• Endlessly Layered Hedging Raises Systemic Risk

• Systemic Risk (Endogenous Factor(s))– Endogenous Factor in (Firms, Industries or)

Markets Threaten Their Collapse – If Market Discipline is Weak then Managed thru

Structural Regulation (“just too darn big to fail”)

Systemic Financial Risk under Reg. Y Proposal

Potential societal impact that individuals or groups of financial institutions impose when they are experiencing “material financial distress [including] the nature, scope, size, scale, concentration, interconnectedness, or mix of the company’s activities, [and this risk] could pose a threat to the financial stability of the United States.

Financial Market Efficiency Requires Financial Information Security

• Traditional Focus:– Vulnerabilities of Data Repositories &

Information Stewardship (Custodial Data)

• Broadening Focus Beyond Databases of Financial Fundamentals (to Technical data) – Systemic Market Integrity Requires Accurate,

Complete & Useful Information• Fundamental Corporate Financials

• Technical Market Transaction Data, the “Book,”

Reveals Systemic Threats

Financial Info. Security Should Address Systemic Risk

• Firm-Specific Security Requires Transaction Verification – Traditional Micro Focus for Fundamental Analysis

• Industry-Specific Risk Mgt Requires Transaction Analysis: Standards & Outliers – Industry Irrationalization

• Suppliers/Customers Impose Vulnerabilities• C-B/A - Standardized Transaction cause Industry-Wide Crisis • Outlier Transactions: Innovations With Opaque Risks

• Economy-Wide Risk– Classic Focus for Systemic Risk Analysis– BUT: CyberSecurity Risk IS (often) Systemic

Security Law & Economics

• L&E Suggests Regulatory Objective– Controls, Checks & Balances Suggest

Regulatory Tool Selection & Deployment

• Security Investment Market Failure– Information Asymmetries – Complex, Layered Supply Chain

• Externalities, Free Riders, Weak Discipline

– Direct Costs, Uncertain Benefits – Incentives to Exploit Vulnerability

Securities Laws Impose Systemic Security Control

• Internal Control Requirement– Foreign Corrupt Practices Act (FCPA)

• Security for Financial Privacy Required– Graham/Leach/Bliley (G/L/B)

• Internal Control for Electronic Records– Sarbanes-Oxley (SOX a/k/a SourBox)

• Risk Assessments Required – Dodd-Frank (D-F)

Network Science as a Systemic Risk Forensic

Network Analysis • Enables Mapping:

– ID known & new members – Monitor flows: information, influence, $, contracts,

exposure, performance risks …– Trust, Task, Money & Resources, Strategy & Goals– Structure of sub-groups or clusters

• E.g., hierarchical, virtual, leaderless, flat orgs

• Enables ID of Centrality, Concentration– Key to Risk Management

• Enables Prevention – Regulation, ad hoc Limitations

• Global Derivatives “Book” IS the Network

Apply Network Analysis to Systemic Financial Risk• Determine Nodes & Links

• Classify links– Timing, Frequency, Volume, Content,

Scale, Indemnity, Recourse

• Test Each Node for Resilience

• Test Cascading Interdependence (Domino Effect)

• See: Easley, David & Jon Kleinberg, Networks, Crowds and Markets:

Reasoning about a Highly Connected World, (Cambridge Press, 2011).

Node & Link Analysis• Betweenness:

– Point is between two other points on the same line if its coordinate is between their coordinates

– From Graph Theory a centrality measure of a vertex within a graph; vertices occurring on many shortest paths between other vertices have higher betweenness than those not

– High Betweeness shows node’s control over the flow in the network suggesting node is a broker, gatekeeper, agent

• Closeness– Measure of node’s ability to access other

nodes &/or monitor events & conditions

Centrality Measures

• Eigenvector Centrality– Determines cause-effect relationships

• Hypothesize:– relationships, – overall network activities, – cumulative strategies & – predict future activities

• Assumptions: Social Networks (SN)– Rule of 150 a scale limitation on SNs

Kreb’s Mapping Method

• Identify, Distinguish Task from Trust Ties– Challenging even for Comprehensive, Exhaustive &

Accurate Data for Transparent Legal Acts– THE Challenge In Analysis of Confidential Financial

Innovation

• Network Links to Map– Trust– Task– Money & Resources– Strategy & Goals

What Barriers Might Prevent Network Science Analysis

• Ideology (ECM) & Politics (jump anti-DF wagon)– Regulatory Avoidance Incentive– Regulation Spoils the “Derivatives Party”

• Dearth of Useful Data– Data (un)Availability, Coding Costs, MIPS

• Systemic Analysis Methods are Immature • Trade Secrecy Incentive

– Transparency of the Book Reveals Proprietary Trading Strategies

– Transparency Undermines Incentive to Invest in Trading Strategy Development

– Might a Privilege Assuage This Concern?

Self-Evaluative Privilege• Protection from Publicizing “the Book”

– Internal Investigations Rely on Atty-Client

– Book Confidentiality part of Specialists “Deal”

• Traditional Privieges: – 5th A. Atty-Client, Dr.-Patient, Psychoanalyst, Accountant,

• Hard to Add New Privileges: – Societal Importance of the Relationship

– Intrusion Offensive to Societal Values

– Expectation of Confidentiality Key to Candor

Confidentiality Essential to Relationship

– Likely Barriers to Relationship w/o Privilege

– Societal Benefits Must Predominate

Rays of Hope for Network• Federal Reserve’s Office of Financial Stability

Policy & Research (OFSPR)– http://www.federalreserve.gov/econresdata/fsprstaff.htm

– Identifies & Analyzes Potential Threats to Financial Stability

– Monitors Financial Markets, Institutions, & Structures

– Assesses & Recommends Policy Alternatives

– Fosters Broader Understanding of Financial Stability Issues

– Longer Term Research: Banking, Finance, & Macroeconomics

• Sponsored Academic Research ?!?

Rays of Hope for Network• Self-Evaluation Privilege: “it could happen”• Data for Network Analysis

– Bankruptcy Transaction Unwinding To Build Analytical Tools (e.g., Bear-Sterns, Lehman Bros, AIG

– Derivatives Transaction Histories, An Inventory & Impact Analysis Of Current Hedge Positions (The Book), Existing Financial Industry Disclosures

• Interpretation Guided by:– Financial Institution Conflicts, Trading Venue Restrictions,

Capital Requirements, Conflicts Rules, Limits Of Mandatory Risk Analytics, Flash Trade Monitoring

• Further, an “Open Source Book” Might Permit Plays Against Systemic Risks – BUT Could Invite Predatory Manipulation