Illustration by Tim Lahan
Illustration by Tim Lahan

Nearly six years after the financial crisis, regulators have adopted a slew of new rules that might make individual banks a little safer. None of the measures, though, adequately addresses a more troubling and hard-to-recognize problem: the risk lurking in the linkages between financial institutions.

New capital and liquidity rules will make banks marginally more resilient to losses and somewhat less susceptible to runs. Measures such as the Volcker Rule in the U.S. and ring fencing in the U.K. will limit big banks' ability to make speculative bets with taxpayer-insured funds. Taken together, the new rules might also encourage the largest banks to become a bit smaller.

The systemic risk posed by a financial company, however, depends on more than its own health and size. The detailed pattern of financial linkages between companies can determine how vulnerable they and the whole system are to shocks. The complex web of the financial network, for example, allowed the 2008 bankruptcy of Lehman Brothers Holdings Inc. to trigger the near-demise of giant insurer American International Group Inc. and a money-market freeze that cut off credit to companies around the world.

The challenge, then, is to encourage financial institutions to “rewire” their interconnections to make the financial network safer. As it turns out, there is a way. Conceptually, it might not even be that hard.

In a new paper, complex-system specialists Sebastian Poledna and Stefan Thurner offer a relatively simple idea: Make banks recognize systemic risk by charging them for creating it. Currently, lenders worry only about the risk they face from a default by the borrower, as opposed to the risk the loan may present to the larger financial system by making cascades of default more likely. Poledna and Thurner suggest that a small tax, proportionate to the systemic risk a loan entails, could help rebalance the incentives.

The tricky part is figuring out how much to charge. I've written before about a potentially revolutionary risk measure called DebtRank, which seeks to assess institutions' systemic importance through a direct analytical assault on the complexity of the financial network. Inspired by algorithms used in Web searching, the method gauges an institution's systemic risk by looking at how many other systemically important institutions are linked to it. Unlike other measures of systemic risk, it takes the entire structure of network interdependence into account.

Poledna and Thurner show that the same thing can be done for any financial transaction -- say, for a loan one bank makes to another. The more connected the counterparties are, and the more links they have to other highly connected counterparties, the greater the systemic risk of a transaction between them. With the right data, one can calculate how much extra risk the deal brings to the overall financial network, and charge a compensating tax.

People in finance are rightly wary of transaction taxes. A blind tax on all transactions could reduce the overall availability of credit, making it harder for individuals and businesses to fund useful economic activity.

A systemic-risk tax, by contrast, doesn’t have to be so crude. It can focus on the transactions that matter, making borrowing from systemically risky banks more costly and giving them an incentive to reduce the risk they pose. Banks would still be free to lend to whomever they want, and the money raised from the tax could go into a bailout fund. Of course, doing this in practice for the most important funding markets would mean forcing banks to make a lot more data available to central banks than they currently do.

To get a sense of how such a transaction tax might work, Poledna and Thurner ran a computer simulation with 20 banks, 100 nonbank companies and 1,300 households. They found -- using data from the interbank lending market -- that the tax didn’t affect the overall volume of credit, and it greatly decreased the risk of cascading failures.

In other words, the good part of global finance could be preserved, with the risky part greatly reduced. Responsible institutions could carry out their business with no impediment, as the tax would apply only to transactions that increase systemic risk. Who could possibly be against that?

Well, it's not attractive to the big financial institutions that currently profit by taking on risks in secret, at taxpayers' collective expense. This is why ideas like a targeted transactions tax face an uphill battle. For the sake of our financial and economic future, let’s hope they get heard.

(Mark Buchanan, a physicist and the author of “Forecast: What Physics, Meteorology and the Natural Sciences Can Teach Us About Economics,” is a Bloomberg View columnist.)

To contact the writer of this article:
Mark Buchanan at buchanan.mark@gmail.com.

To contact the editor responsible for this article:
Mark Whitehouse at +1-212-617-5431 or mwhitehouse1@bloomberg.net.