Surely I did not come up with the title phrase of this story. I borrow it from an Australian physicist, who then became a biologist, who became an Oxford Don, and then a Peer of England, and after all this a financial systemic risk modeler. This can be no other but Professor Lord Robert May, Baron May of Oxford. His proposition on systemic financial risk is quite simple. The financial system, including the insurance and reinsurance firms, is one large organism. Where firms of various sizes are inter-connected and inter-dependent. The larger the firm, in terms of assets and risk exposure, the more complex connections it bares to other firms and to the system as a whole. Larger scale means disproportionately larger risk. This is a thesis in opposition of the traditional financial theory of diversification, which states that with size and distributed exposures come the benefits of diversification. Biological theory however, from its first principles, states that the larger the unit in a biological system or organism the more inter-connected and inter-dependent it becomes on other units and on its living environment as a whole. This makes it more complex and harder to survive a systemic shock. Simple organisms adapt and survive crisis and shock better than large and complex ones. Should these principles apply to the financial system and its firms? If they do, then it is scale and not diversification that defines risk management and capital reserving. Large scale requires disproportionately larger reserves and disproportionately more intense precautions. Mathematicians call this effect super-additivity. Diversification, de-concentration and sub-additivity remain proved principles of classical financial theory [Some of 2017 seminars' notes are at this link : ... ] Still on a systemic level, it is critical to understand which principle dominates and defines risk management and capital reserving practices. Let’s talk about this next month at AIR’s Envision 2018 conference.
Category: Climate/natural disasters: Climate change, Disaster risk, Resilience
Location: Cambridge, MA, USA