On fish and finance

It might seem that fisheries management and financial regulation have little in common. Bankers have been accused of many things recently, but only rarely of being slippery underwater creatures with gills

April 20, 2011

However, the two fields of fisheries and finance do share certain properties. Their overseers are both charged with the management of complex ecosystems, either of different ocean species, or of different investor species. They each have to deal with sudden, apparently inexplicable crashes – in fish populations, or markets. And increasingly, they are adopting the same kind of approach to their work, based on systems science, of the sort championed by people like the ecologist Robert May.

While studying the behaviour of fish populations in the 1970s, May discovered that populations could boom and bust purely as a result of their internal dynamics, without any need of external shocks. Instead of trending towards equilibrium, as assumed by the conventional “balance of nature” theory, they were intrinsically unstable. His work helped drive the development of chaos theory. Today, though, his attention has turned towards a different kind of chaos – that of the financial markets.

As he pointed out in a recent paper in Nature, co-written with the Bank of England’s Andrew Haldane, one of the reasons for the credit crunch was because risk was assessed for individual firms rather than for the system as a whole. Risk metrics such as Value at Risk (VaR), for example, calculate the risk for a particular firm’s financial position, but don’t reflect systemic risk which results from the net action of all the firms. The result during the early 2000s was that systemic risk – in the form of ballooning credit – was allowed to accumulate. As individuals, banks were meeting their requirements, but as a system, the financial network was getting deeper underwater.

Until recently, fisheries management had a similar problem. It was performed on a single species basis, with catch limits determined according to population levels. This approach failed to prevent disasters such as the collapse of the Grand Banks fishery off the coast of Nova Scotia, Canada. It was soon realised that, because each species is just one link in a complicated food chain, it is impossible to assess the risk of collapse for any species in isolation. Instead, the entire eco-system has to be taken into account. The result was ecosystem-based fisheries management.

Clearly, financial regulators can learn much from fisheries management. As May told the Financial Times, “The more I hear about financial economics, the more I am struck by its similarity to ecology in the 1960s.” The time has come for a systemic approach to risk.

In 2007, a team of fisheries experts came up with a list of ten commandments for ecosystem-based fisheries.* In case it is of use for financial regulators, we here present the same list, along with the appropriate finance interpretation.

1. “Keep a perspective that is holistic, risk-adverse and adaptive.”
Risk measurement in financial systems is currently evaluated on a case-by-case basis for each institution. This gives little idea of the overall risk of the entire network. We should therefore supplement single-firm metrics such as VaR with adaptive techniques that adjust for systemic risk. For example, margin requirements and minimum capital requirements could be tightened during a boom, and relaxed during a bust.

2. “Question key assumptions, no matter how basic.”
That would include the assumptions that markets operate at equilibrium, or that people behave in a rational, non-fishy manner.

3. “Characterise and maintain ecosystem resilience.”
Banks should have sufficient reserves to pass stress tests which include the possibility of extreme events. Diversification is also important – though as May points out, it isn’t enough for institutions just to diversify their investments amongst different asset classes, they have to do it in different ways (otherwise there is no real diversity).

4. “Characterise and maintain the natural spatial structure of fish stocks.”
Robust ecosystems such as food webs tend to be built up of a number of separate, weakly connected subnetworks. The international finance system has become increasingly connected in recent years, and a degree of modularity could similarly make it more robust. One possibility is to structure global banks into national subsidiaries, so that if one part gets into trouble it won’t spread internationally.

5. “Identify and maintain critical food-web connections.”
Complexity scientists are starting to analyse the finance system to understand the relationships between different players and investment strategies, in the same way that ecologists monitor the interactions between species in an ecosystem. This should help identify the sources and indicators of systemic risk.

6. “Characterise and maintain viable fish habitats.”
In other words, don’t forget the real economy. No bottom-trawling or ripping up local habitats, as happened during the subprime crisis. And make the regulatory environment fair and transparent, so institutions feel happy and safe.

7. “Account for ecosystem change through time”
For example due to climate change. Regulations have to be constantly updated to keep up with both financial innovation, and with new markets such as carbon trading.

8. “Account for evolutionary changes caused by fishing.”
Just as fishing changes the composition of the ecosystem, so financial regulation changes the composition of the financial system. For example, restricting a particular financial product in too narrow a manner may result in a bloom of new but related products to fill the available niche.

9. “Maintain old growth age structure in fish populations.”
New products offering supposed benefits need to be scrutinised carefully before being adopted. Other critical industries (e.g. pharmaceutics, nuclear) only allow new technologies once they are shown to have demonstrable benefit without dangerous side-effects.

10. “Implement an approach that is integrated, interdisciplinary, and inclusive.”
Finally, be open to ideas and methods from other areas of science – such as fisheries management.