In the run-up to the recent financial crisis, an increasingly elaborate set of financial instruments emerged, intended to optimize returns to individual institutions with seemingly minimal risk. Essentially no attention was given to their possible effects on the stability of the system as a whole. Drawing analogies with the dynamics of ecological food webs and with networks within which infectious diseases spread, we explore the interplay between complexity and stability in deliberately simplified models of financial networks. We suggest some policy lessons that can be drawn from such models, with the explicit aim of minimizing systemic risk.

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Credit cycles have been a characteristic of advanced economies for over 100 years. On average, a sustained pick-up in the ratio of credit to GDP has been highly correlated with banking crises. The boom phases of the cycle are characterised by large deviations in credit from trend. A range of mechanisms can generate these effects, each of which has strategic complementarity between banks at its core. Macro-prudential policy could curb these credit cycles, both through raising the cost of maintaining risky portfolios and through an expectations channel that operates via banks' perceptions of other banks' actions.

Financial markets have historically exhibited sudden and largely unforeseen collapses, at a systemic scale. Such "phase transitions" may in some cases have been triggered by unpredictable stochastic events. More often, however, there have been endogenous underlying processes at work. Analyses of complex systems ranging from the climate to ecosystems reveal that, before a major transition, there is often a gradual and unnoticed loss of resilience. This makes the system brittle: A small disruption can trigger a domino effect that propagates through the system and propels it into a crisis state.

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