This is a really important paper which will help set the agenda for scientific work on banking ecosystems for some years. It also has significant messages for the financial community. It draws attention to the dangerously flimsy foundations of derivatives pricing, to the importance of network effects, and to the fundamental problem, which we call the Regulator’s Dilemma, that reducing risks for each individual bank can increase the risks to the system as a whole, a problem which is made even worse when you consider the effect of bank failures on the wider economy.
A lot of work is needed to develop the insights from these theoretical models into practical regulatory tools, and we’re working on this with leading investors, regulators and academics. But at least we’re now able to ask some of the right questions, which previously had been overlooked due to a lack of basic theoretical understanding.
As for making a detailed micro-foundations model of bank behaviour, this is a long way beyond the state of the art. Economists like Ned Phelps fully understand that
rational expectations models cannot really describe financial markets, but no-one yet really knows what to put in their place. And in reality banks are highly complex social systems, where people behave in accordance with complex incentives and belief systems that cannot be captured mathematically. The only certainty is that any explicit model of bank behaviour that became part of a regulatory system would then be gamed by the banks trying to circumvent it. We don’t prevent collisions in yacht races by making behavioural models of crew, but by having robust rules for the prevention of collisions at sea.
I met up with my Cambridge contemporary Robert MacKay and now I'm trying to learn a bit about Additive Combinatorics - which sounds fascinating though I'm sure the maths is way way beyond me. There is a book by Terence Tao whose review by Ben Green has been enough to get me to order it.