When multiple banks invest in the same asset, it creates a potential route of transmission between them. If a crisis hits and one bank starts selling off its assets, it will affect all the other firms who hold these investments. The more the largest banks diversify their investments, the more opportunities for shared contagion. Several studies have found that during a financial crisis, diversification can destabilise the wider network.[90]
Robert May and Andy Haldane noted that historically, the largest banks had held lower amounts of capital than their smaller peers. The popular argument was that because these banks held more diverse investments, they were at less risk; they didn’t need to have a big buffer against unexpected losses. The 2008 crisis revealed the flaws in this thinking. Large banks were no less likely to fail than smaller ones. What’s more, these big firms were disproportionally important to the stability of the financial network. ‘What matters is not a bank’s closeness to the edge of the cliff,’ May and Haldane wrote in 2011, ‘it is the extent of the fall.’[91]
Two days after lehman went under, Financial Times journalist John Authers visited a Manhattan branch of Citibank during his lunch break. He wanted to move some cash out of his account. Some of his money was covered by government deposit insurance, but only up to a limit; if Citibank collapsed too, he’d lose the rest. He wasn’t the only one who’d had this idea. ‘At Citi, I found a long queue, all well-dressed Wall Streeters,’ he later wrote.[92] ‘They were doing the same as me.’ The bank staff helped him open additional accounts in the name of his wife and children, reducing his risk. Authers was shocked to discover they’d been doing this all morning. ‘I was finding it a little hard to breathe. There was a bank run happening, in New York’s financial district. The people panicking were the Wall Streeters who best understood what was going on.’ Should he report what was happening? Given the severity of the crisis, Authers decided it would only make the situation worse. ‘Such a story on the FT’s front page might have been enough to push the system over the edge.’ His counterparts at other newspapers came to the same conclusion, and the news went uncovered.
The analogy between financial and biological contagion is a useful starting point, but there is one situation it doesn’t cover. To get infected during a disease outbreak, a person needs to be exposed to the pathogen. Financial contagion can also spread through tangible exposures, like a loan between banks or an investment in the same asset as someone else. The difference with finance is that firms don’t always need a direct exposure to fall ill. ‘There’s one way this is unlike any other network we’ve dealt with,’ said Nim Arinaminpathy. ‘You can have apparently healthy institutions come crashing down.’ If the public believes that a bank will go under, they may try to withdraw their money all at once, which would sink even a healthy bank. Likewise, when banks lose confidence in the financial system – as happened in 2007/8 – they often hoard money rather than lending it out. The rumour and speculation that circulates from one trader to another may therefore bring down firms that would otherwise have survived the crisis.
During 2011, Arinaminpathy and Robert May worked with Sujit Kapadia at the Bank of England to investigate not only direct transmission through bad loans or shared investments, but also the indirect effect of fear and panic. They found that if bankers started hoarding money when they lost confidence in the system, it could exacerbate a crisis: banks that would otherwise have had enough capital to ride it out would instead fail. The damage was much worse when a large bank was involved because they tended to be in the middle of the financial network.[93] This suggested that rather than simply looking at the size of banks, regulators should consider who is at the heart of the system. It isn’t just about banks being ‘too big to fail’; it is more about them being ‘too central to fail’.
These kinds of insights from epidemic theory are now being put into practice, something Haldane described as a ‘philosophical shift’ in how we think about financial contagion. One major change has been to get banks to hold more capital if they are important to the network, reducing their susceptibility to infection. Then there is the issue of the network links that transmitted the infection in the first place. Could regulators target these too? ‘The hardest part of this was when you went to questions of “Should we act to alter the very structure of the web”?’ Haldane said. ‘That’s when people started to kick up more of a fuss because it was a more intrusive intervention in their business model.’
In 2011, a commission chaired by John Vickers recommended that larger British banks put a ‘ring-fence’ around their riskier trading activities.[94] This would help prevent the fallout from bad investments spreading to the retail parts of banks, which deal with high-street services like our savings accounts. ‘The ring-fence would help insulate UK retail banking from external shocks,’ the commission suggested. ‘A channel of financial system interconnectedness – and hence of contagion – would be made safer.’ The UK government eventually put the recommendation into practice, forcing banks to split their activities. Because it was such a tough policy to get through, it wasn’t picked up elsewhere; ring-fencing was proposed in other parts of Europe, but not implemented.[95]
Ring-fencing isn’t the only strategy for reducing transmission. When banks trade financial derivatives, it’s often done ‘over the counter’ from one firm direct to another, rather than through a central exchange. Such trading activity came to almost $600 trillion in 2018.[96] However, since 2009, the largest derivatives contracts are no longer traded directly between major banks. They now have to
