Critical Perspectives on the Evolution of American and British Banking
Edited by Matthew Hollow, Folarin Akinbami and Ranald Michie
Chapter 1: Financial innovation and the consequences of complexity: insights from major US banking crises
The role of financial innovation in the recent global financial crisis has been explored extensively, but discussion on the relationship between innovation and financial crisis in general is largely missing. Drawing from the literature on complex adaptive systems and the narratives of six major US banking crises – occurring in 1792, 1873, 1893, 1907, 1930–33 and 2007–08 – we propose the Innovation–Complexity hypothesis: under certain conditions, innovation in financial instruments, institutions and markets amplifies certain negative dynamics of complexity in the financial system; this amplification increases the fragility of the system and thus the likelihood of a financial crisis. We highlight two mechanisms through which this amplification can occur: in the creation of tight linkages and in an increase in informational opacity. Financial contracts link different parts of a financial system. Certain innovations can turn these linkages into chains of dependencies, such that the survival of one part of the system becomes dependent on the performance of another. Moreover, trouble can flow more easily from one part to another through these tight linkages. Innovations can also make a system more opaque, and thus more susceptible to information asymmetry, whose role in financial crisis is well understood. In addition, this opacity makes it difficult for financial system participants and regulators to locate the source of possible trouble and the channels of its propagation.