OPINION

Opinion: A new approach tofinancial regulationSimon A. Levina,1 and Andrew W. Lob

aDepartment of Ecology and Evolutionary Biology and Center for BioComplexity, PrincetonEnvironmental Institute, Princeton University, Princeton, NJ 08544-1003; and bLaboratoryfor Financial Engineering, Massachusetts Institute of Technology Sloan School ofManagement, Cambridge, MA 02142

It has been five years since the US Congressenacted the landmark Dodd–Frank WallStreet Reform and Consumer ProtectionAct; and despite the fact that about 20% ofthe Act has yet to be implemented (1), severallegislative initiatives are now attempting tosoften or roll back key provisions. This pat-tern of regulatory action and reaction is notnew. The financial excesses of one period of-ten lead to asset bubbles that burst, usheringin a new period of much greater regulation.

This, in turn, is systematically weakened overtime as markets recover and we forget thereasons why we imposed such stringent reg-ulations in the first place. Even before Dodd–Frank, the financial industry was among themost highly regulated of industries in theworld. However, the many layers of regula-tion and multiple regulatory agencies wereinsufficient to prevent financial crisis. Why?We propose that the financial system has

crossed a threshold of complexity where the

system is evolving faster than regulators andregulations can keep pace. For example, thesystem is now truly globally connected, butcoordination across sovereign jurisdictions isdifficult to achieve. This new situation calls fora new perspective, one based on a differentparadigm than the ones on which financialregulation is currently based, such as efficientmarkets, rational expectations, and modelspatterned after the physical sciences.The challenge of complexity is not unique

to finance but applies as well to other humanendeavors, including the management of en-vironmental systems, international relations,cyberterrorism, and bioterrorism. In somecases, this challenge has been met success-fully by implementing perspectives andmethods from evolutionary biology, gametheory, and complex systems theory, in part-nership with domain experts in each fieldof application.These ideas have generally not been ap-

plied to financial regulation, despite a Na-tional Research Council report on systemicrisk that was cosponsored by the FederalReserve Bank of New York and the NationalAcademy of Sciences to encourage such part-nerships (2), and sympathetic perspec-tives by prominent regulatory insiders (3, 4).Evolutionary principles have, of course,been applied to many economic contexts,but they have had little impact to date on fi-nancial regulation. Here, we advocate chang-ing the regulatory ecosystem by proposingcollaboration among experts in various dis-ciplines and professions.Biological systems have faced a range of

challenges throughout evolutionary history,and this has led to solutions that are adaptive,hierarchical, modular, and with sufficientredundancy to minimize the chances ofcollapse. We can learn a great deal frombiological systems in designing new regu-latory frameworks for financial systems,which face similar challenges. We do not

Our financial system is arguably on shaky ground. Could principles from biology and ecologyinspire better ways to maintain stability? Image courtesy of Dave Cutler.

Author contributions: S.A.L. and A.W.L. wrote the paper.

1To whom correspondence should be addressed. Email: slevin@princeton.edu.

Any opinions, findings, conclusions, or recommendations ex-

pressed in this work are those of the authors and do not necessarily

reflect the views of the National Academy of Sciences.

www.pnas.org/cgi/doi/10.1073/pnas.1518385112 PNAS | October 13, 2015 | vol. 112 | no. 41 | 12543–12544

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yet, however, know how to do so except ina small fraction of cases.Therefore, we propose an interdisciplinary

research agenda that will apply principleslearned from how evolution has built bi-ological systems to financial regulation. Wehave only the broad outlines of such anapproach today; hence, the call for newresearch. However, as proof of principle, weprovide a few concrete examples of specificinsights that evolutionary biology and ecol-ogy can offer to current financial regulatorychallenges: (i) too big to fail, (ii) adaptiveregulation, (iii) homeostatic mechanisms,and (iv) robustness and resiliency.Too big to fail: The physical size of an

organism is determined by a combinationof environmental, physiological, and evolu-tionary factors that can be measured and pre-dicted. Analogous to cancer, uncontrolledgrowth can then be understood as some al-teration or disruption of these factors.Moreover, just as cancers are difficult tocombat because they are not foreign in-vaders but part of our own bodies, largefinancial institutions play vital roles inour economy. A biological approach to un-derstanding the growth of banks may offera more permanent solution to the too-big-to-fail problem, which has become evenmore problematic after the 2008 FinancialCrisis; remarkably, the largest banks areeven larger and more interconnected todaythan in 2007 (5). It was that interconnec-tedness that sowed the seeds for the crashof 2008–2009 (6), and hence remains acause for concern (3).Adaptive regulation: The vertebrate im-

mune system evolved to address the certaintyof unpredictable assaults on the body. It in-volves a combination of surveillance, recogni-tion of invasion, rapid generalized responses,adaptive longer-term responses, and memory.Financial regulation lacks many of these com-ponents as part of a well-developed system ofprotocols, but they are needed. We believe wecan build such features into regulation, and weprovide a specific proposal: allow regulatoryleverage restrictions to adapt to time-varyingrisk levels of an institution’s assets as well as thelevel of aggregate risk in the macroeconomy.Homeostatic mechanisms: Regulatory

feedback loops in nature involve activa-tion and inhibition acting on compatibletime scales. When this symmetry is broken,as for example when the regulatory mecha-nism is delayed in its implementation, po-tential fatal pathologies, like Cheyne–Stokesbreathing (rapid cycles of hyperventilationand apnea) may result. Similarly, financial in-novation, sometimes augmented by governmentpolicy, can lead to cancer-like unchecked growth

of components of the system, threatening thestability of the entire system. The solutions mustinvolve either more adaptive regulatory mecha-nisms that can keep up with financial innova-tion or the imposition of frictions to slowgrowth (e.g., leverage limits, transaction taxes,licensing, and registration hurdles).Robustness and resiliency: Perhaps the

most important consequence of the FinancialCrisis of 2008 is the new realization that thecurrent financial system is not robust; threatsto financial stability can arise from surprisingquarters. We propose applying the notion ofecosystem robustness, which is characterized byfour properties—redundancy and degeneracy,

We can learn a greatdeal from biologicalsystems in designingnew regulatory frame-works for financialsystems.diversity and heterogeneity, modularity, andtightness of feedback loops (7)—to financialregulation. These concepts imply that currentregulatory oversight is inadequate, and currentefforts to centralize regulatory authority couldactually contribute to financial instability.These examples are not meant merely as

analogies to financial contexts. Rather, theyare biologically equivalent contexts in whichevolution has produced successful mecha-nisms to specific challenges to stability andsurvival through competition, innovation, andnatural selection. The economy is, after all, theproduct of the machinations, institutions, andinteractions of individuals from one particularanimal species, Homo sapiens. The uniqueabilities of our species—abstract thought, for-ward-looking and planning behavior, andsocial interactions, including sophisticatedcommunication, computation, and large-scalecooperation—imply that the interactions areparticularly subtle and complex. Nevertheless,they are still the product of animal behaviorand the sooner we acknowledge this fact ofnature, the sooner we can explore novel ap-proaches to improving financial regulation.

The language and tools of biology—espe-cially ecology and evolutionary biology—areideally suited for analyzing the trade-off be-tween exploration and exploitation. This is nota simple optimization problem because of theadaptation that economic agents undergo inresponse to the changing conditions they cre-ate, something economists have been keenlyaware of since Robert Lucas (8) critiquedKeynesian macroeconomic policy for ignoringthe fact that rational economic agents can an-ticipate policy changes and respond optimally.However, these so-called dynamic stochasticgeneral-equilibrium models have been of lim-ited utility in guiding regulators toward spe-cific policy recommendations to manage thisbalance (9, 10).A biological perspective neatly addresses

the Lucas critique (8): both the regulatorsand the regulated are part of a much largerfinancial ecosystem. Their strategies evolvetogether, as a result of the changes in thefinancial environment they themselves cre-ate. This approach implies that the influenceof regulators and the regulated on one an-other, and the feedback loops they face,must also be included in policy decisions.Unless we approach the financial system as

an ecosystem when adopting, revising, imple-menting, and evaluating regulations, we areunlikely to achieve our twin objectives ofsustained economic growth and financialstability, just as Lucas (8) warned nearly 40years ago. Our hope is to motivate financialregulators, economists, ecologists, evolution-ary biologists, and complex systems theoriststo collaborate on developing a new paradigmfor regulating the financial system because thecurrent paradigm is not sufficient. Wherethere has been success in other systems, ithas come from the active engagement andinteraction of multiple stakeholders, each con-tributing unique expertise to develop a morecomplete and integrated approach to systemsmanagement. Historically, regulators have notbeen engaged in such research, but the expe-rience of 2008 has made clear just how crucialand beneficial this new approach could be.

1 Polk D (2015) Dodd–Frank Progress Report: First Quarter 2015(Davis Polk, New York).2 Kambhu J, Weidman S, Krishnan N (2007) New Directions forUnderstanding Systemic Risk: A Report on a Conference Cosponsored bythe Federal Reserve Bank of New York and the National Academy ofSciences (National Academies, Washington, DC).3 Haldane AG, May M (2011) Systemic risk in banking ecosystems.Nature 469(7330):351–355.4 Taylor C (2011) Evolution and Macro-Prudential Regulation(American Enterprise Institute, Washington, DC).5 International Monetary Fund (2015) United States FinancialSystem Stability Assessment (International Monetary Fund,Washington, DC), p 7.

6 May RM, Levin SA, Sugihara G (2008) Complex systems: Ecologyfor bankers. Nature 451(7181):893–895.7 Levin SA (1999) Fragile Dominion: Complexity and the Commons(Perseus Books, Reading, MA).8 Lucas R (1976) Econometric policy evaluation: A critique. ThePhillips Curve and Labor Markets, eds Brunner K, Meltzer A (Amer-ican Elsevier, New York), Vol 1, pp 19–46.9 Dotsey M (2013) DSGE models and their use in monetarypolicy. Federal Reserve Bank of Philadelphia Business Review.Q2:10–16.10 Lo A (2014) Macroeconomic modeling and financialstability: Lessons from the crisis. Banking Perspective. 2(4):22–31.

12544 | www.pnas.org/cgi/doi/10.1073/pnas.1518385112 Levin and Lo

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