Beyond dog-eat-dog

27 February 2012 | Updated: 28 February 2012 10:38 am | By Samuel Dale

Lord Robert May is certainly the most distinguished and perhaps the most unusual person to appear in Lending Zone. A renowned ecologist by trade, he has recently taken an interest in banking and how eco-systems can help us understand the financial system.

He has taken part in Bank of England seminars and has been consulted on banking reform by Sir John Vickers, chairman of the Independent Commission on Banking.

In January 2011 he co-authored a paper with Andrew Haldane, executive director of financial stability at the Bank of England, in Nature magazine. The pair examined what natural eco-systems can teach us about the complexity of the modern banking system and how to make it safer.

It may seem a strange move for an ecologist, but Lord May’s career has seen him working in a vast array of fields and places.

His work led to his knighthood while he was chief scientific adviser to the UK government between 1995 and 1999.

And he followed in the footsteps of Sir Isaac Newton, Thomas Huxley and Samuel Pepys as president of science body the Royal Society from 2000 to 2005.

Born in Australia in 1938, Lord May studied theoretical physics at Sydney University, quickly followed by a PHD. He was all set to move to Geneva, where his thesis supervisor was taking up the first chair in theoretical physics. But the unexpected death of his supervisor in a light aircraft crash in the Australian outback drastically changed his plans.

“I was saddened,” he says. “But it meant I went to do a post-doctorate at Harvard university, which is where I met my wife, so it was a critical juncture in my life. I then went back to Sydney and had the first personal chair created as professor of physics.”

Through his work with the movement for social responsibility in Australia, Lord May began to take an interest in ecology, a new topic in the 1950s.

The consensus was that the more complex an ecosystem was, the more stable and safe it became, but Lord May found this counter-intuitive. He produced studies to show it was actually simplicity that created stability, and this led to him becoming professor of biology at Princeton university in the United States.

He has studied ecology ever since and currently resides as a professor in the department of zoology at Oxford university.

Banking calling

His career veered towards banking after he taught George Sugihara, a brilliant Oxford student with whom he produced a paper on complex networks in 1990. In the 1990s, Sugihara became a managing director of quantitative finance at Deutsche Bank, earning millions before returning to academia.

Then, in 2006, the US National Academy of Sciences and the Federal Reserve of New York published a study about the increasingly complicated instruments that banks were trading, such as derivatives.

“They thought it would be interesting to get some read-across from other areas, such as ecology, infectious diseases and the electricity grid,” says Lord May. “Sugihara was a natural choice because he was an ecologist who ran major investments for a bank, and he got me involved.”

Meeting King

The study sparked his interest in the subject and in the middle of the financial crash in 2008, Lord May approached Bank of England governor Mervyn King about holding a seminar.

He wanted to bring together key Bank staff and leading ecologists to consider whether lessons from ecosystems could help to build a safer financial system.

“I was chief scientific adviser to the government in the 1990s, a type of permanent secretary position with an amusing and different culture, and became friendly with King,” he says. “I asked him to get Sugihara and I together with some of the Bank’s bright people to talk about systemic issues in finance.”

The seminar was arranged for early 2009 and Lord May prepared by trying to understand the banking system further.

“I did some simplistic analysis of the network of banking and recognised it was far more complicated than eco-systems,” he says. “The nodes in the eco-system network are species and the connections are something eating something else.

“But the nodes in a banking system involve retail plus investment banks with connections including credit coming in from outside, inter-bank loans coming in from within the system, loans going out in the form of mortgages, and inter-bank loans going out but remaining within the system.”

In response to this complexity and using his ecological background, he argued for simplified structures and safer systems. At the Bank seminar, Lord May made the case for a separation of retail and investment banking to achieve this.

“One of the ideas I presented at the seminar came from a simulation of the simplest form of systemic shock - loan defaults,” he says. “The model did not include any other shocks and it showed that the losses could be distributed among more banks and smoothed out.

“Individual banks wanted to ensure the shock was spread among as many banks as possible. I found that it’s easier for banks to absorb a loan default shock if the retail and investment arms are separated as it is contained. This caused a slight stir.”

The ICB has since proposed to ring-fence investment and retail arms and the government has accepted the reforms.

Super-spreaders of infection

When Lord May was consulted by Vickers about the report he stressed further applications of ecology to finance.

Simplifying the system will help but banking also needs extra precautions against the ’super-spreaders’ of infection in the network. For example, during the SARS epidemic, certain individuals infected dozens of others while some infected very few. Applied to the banking system, problems at a major bank would infect many other institutions, while the closure of a small building society may have limited impact.

Dealing with super-spreaders is crucial to tackling infectious disease, just as protecting the system against the contagion of big bank failures is needed to make it more robust.

“The ICB report is about taking sensible measures to make the system more robust,” he says. “Proposals include ring-fencing and the need for banks to hold more capital reserves, particularly to make larger banks hold relatively more capital.

“The big banks need to be specifically dealt with as they are more important, like super-spreaders of infection.”

Ratings rage

There are two more areas where Lord May believes ecosystems can help finance build simpler and more robust systems.

First, he believes accurate product pricing has been made far more difficult by rating agencies’ ineptitude or crookedness.

He says that just as one species will assess the danger from others, unless risk can be appropriately assessed then a system will never work effectively,
“I would like to see more attention given to how the increasingly elaborate instruments now traded are being rated,” he says. “They are rated by private agencies, whose past record is one of demonstrable incompetence.”

He suggests these instruments are broken down into simpler forms so effective risk assessment can take place.

“These complex instruments are hard to penetrate and I can see the difficulty, as Vickers says, in choosing who will decide what is too complicated.” he says.

“Vickers was not asked to consider it in his report but I’d like to see more attention to it.”

The other area Lord May believes needs reform is the speed of trading of such complex products.

Fat finger syndrome is well known in the City and happens when a trader presses a button in error, causing a temporary plunge in stock markets, with millions of pounds lost and regained within moments.

“There are parallels with excessively complicated ecosystems that will be destabilised by their complexity,” he says. “There are more and more complicated products with faster and faster trading. I accept my financial knowledge is limited, but if I were supreme dictator I would ask whether we should be putting a limit on how fast you can trade.

“It can be done with an explicit time limit - a nano-second or half a second - or with a financial transaction tax that will have the effect of slowing it down. Try to put some range on just how complicated these things are.”

Moving forward

A man of Lord May’s distinction is well worth listening to and senior regulators, governments and bankers take seriously his views on building safer systems in a post-crash world.

He’s not a politician or banker and doesn’t claim to have all the solutions but his understanding of how systems fit together provides a different perspective.

“There are no easy answers,” he says. “I am good at understanding what is going on but often when you realise what is happening then it is really hard to fix it.”

If you enjoyed this article, sign up here to receive daily email updates from Mortgage Strategy and Follow @mortgagestrat

Have your say

Please do not complete the following form field for security reasons.

Name

E-mail

Comment

Post as

Anonymously

Display name

I have read and agree to the terms and conditions