Holding back evolution March 30, 2012 at 7:26 am

Hans asked a good question in comments to a prior post:

when you start off with 40 medium size banks, eventually a few will have a better business model than the others. And then the business model gets copied (due to shareholders seeing the return at the more successful banks and wanting the same) which leads to a convergence to 40 banks with (more or less) the same business model. Basically what we saw in the run-up to the financial crisis. After which the take-overs can begin due to economy of scale.

In other words: I agree that ‘evolution’ thrives on diversity, but how do you prevent convergence to one (or 2/3) business models?

I have to say that that one has me stumped for now. The fitness landscape changes fast for banks, so rapid change (what an evolution biologist would call Saltation) is the norm. If we let evolutionary pressure bear on a diverse set of creatures in a fitness landscape with a single peak – a single business model – the ones that don’t climb the peak aren’t very successful. So do we have to imagine legislators coming in like comets every 50 years and imposing diversity again? That’s pretty depressing.

The problem is the premise: a single-peaked fitness landscape. Diversity is encouraged when there are lots of local maxima in the fitness landscape. We need, in other words, to make sure that lots of banking different models are acceptably profitable. There are two ways to do this of course: lifting up the little guys (aka the wildlife sanctuary approach) or crushing the big guys (aka a cull). To your elephant guns, gentlemen.

10 Responses to “Holding back evolution”

  1. […] Getting the banking ecosystem right. Elephant guns at the […]

  2. Great question.

    If the banks arent permitted to get past size X of their balance sheet then wouldnt they just get together into cartels and share some of the work?

  3. … the convergence to a similar business model was driven by more leverage, and thus more profits as long as things went well.

    A classic rift between the positive for employees and shareholders, versus the negative for taxpayers.

    I have issues with describing more reckless as evolution, I prefer to call it reacting to misguided incentives.

    The point is not the size of the balance sheet, rather the leverage ratio (visible and unvisible, as partly hidden by the derivative netting rules).

  4. “So do we have to imagine legislators coming in like comets every 50 years and imposing diversity again? That’s pretty depressing.”

    We don’t need legislators to do this, simply don’t bail them out and let things take their course …

  5. Too Big To Fail is not synonymous with evolution and I don’t think we want (much) evolution in banking anyway. What we want is more like domesticated livestock that provide a useful and predictable function. Most banking should be utilitarian and boring (mooooo!).

    Most financial “innovation” of the last couple decades has arguably been a step backwards…and ended up abetting TBTF. There aren’t any new and wonderful ways to price risk or substitute for transparent and accessible markets and there never will be. Plenty of (private) space should be made for hedge funds, PE, investment banking etc. but away from the gears of commercial and retail banking…and yes those areas should be subject to the laws of the jungle.

  6. I like the domesticated animals analogy. That of course is arbitrary engineering of the fitness landscape; you put up fences to stop the wild critters from getting at your cows.

    I have also learned that if you google ‘elephant guns’ you pretty quickly get to some pretty scary pages. My favourite line so far is “The 550 Magnum will push a 700 grain bullet close to 2400 f.p.s. if the shooter can stand behind the rifle.” It turns out that elephant guns suffer from a similar problem to regulatory reform: the recoil is a bitch.

  7. Well, I would say that banks/livestock aren’t/shouldn’t be the result of “arbitrary” but seriously considered, time-tested and heuristically tempered engineering of the fitness (natural) landscape. This is also more or less the basis and mechanism for civilization itself. Some works of Man, like the wheel, should simply be considered part of the permanent collection.

    The biggest gun I ever held was an antique, double barreled, 2-gauge shotgun which was so big and heavy (you could fit Red Bull cans in the barrels) I could barely hold it up and level. It turned out that the thing was actually designed to be loaded with very small shot and fired like a mortar with its stock planted in the ground…or actually the bottom of a small boat. The idea was you drift down the river and blow away a flock of small birds thusly as they get spooked into the air. Probably an unflattering big bank analogy in there somewhere.

  8. This is related to the topic of metaheuristics. The field is centered around the following situation: you have some parameter space and some fitness function that you’re trying to maximize. A typical scenario would be a doing a non-linear regression and finding the model parameters that maximizes fit on a dataset. In the scenario there’s no analytical solution (e.g. in linear regression) so the only thing you can do is successively try points until you exhaust your resource/computational/time limits. Then you hope that you’ve converged somewhere close to the global maximum or at least a really good local maximum.
    http://en.wikipedia.org/wiki/Metaheuristic

    The central issue in metaheuristics is the “exploitation vs exploration” tradeoff. I.e. do you spend your resources looking at points in the neighborhood of your current maximum (climbing the hill you’re on)? Or do you allocate more resources to checking points far away from anything you’ve tested so far (looking for new hills).

    One of the most reliable approaches is simulated annealing. You start off tilting the algorithm very far towards the exploration side, casting a wide net. Then as time goes on you favor exploitation more and more, tightening on the best candidates.
    http://en.wikipedia.org/wiki/Simulated_annealing

    I believe the boom/bust cycle of capitalism operates very much like simulated annealing. Boom periods when capital and risk is loose tend to heavily favor exploration. It’s easy to start radically new businesses. Bust periods tend to favor exploitation. Businesses are consolidated and shut down. Out of those new firms and business strategies from the boom periods the ones that proved successful go on to survive and are integrated into the economic landscape (Google), whereas those that weren’t able to establish enough of a foothold during the boom period get swept away (Pets.com).

    All of this is tangentially related, but it brings up an interesting question. Most of the rest of the economy (technology is particular) seems to be highly explorative during boom times. Banking in contrast seems to be exploitive during boom times, i.e. banking business models seem to converge to each other. Busts seem to fragment banking models and promote exploration.

    So why is banking so different that the relationship seems to get turned on its head? And is this a bad thing for the broader economy, and if so why?

  9. I believe that there is a lot of liability claims to be made by shareholders to many boards in the European banking landscape. Even so the shareholders of course should have taken a more responsible approach. How do you get activist shareholders, when the price of the share is going the shareholders direction?

    The Brandesian view, that banks can become too big to effectively regulate, hence they must be broken up, are almost impossible under the current regulation boom. Out of necessity to cope with all sorts of legislative creativity, we will see if not direct mergers, a lot of cooperation effectively limiting competition.

    If you bring out the elephant guns, the smaller animals left will just have to work together to do the elephants work.

  10. […] had a very interesting comment to my post about evolutionary diversity and banking. I’ll set up the problem, then quote some of his comment and try to give my spin on his […]