There are perhaps three key robustness results from this literature which are relevant to the financial system. Perhaps the key one concerns the “robust-yet-fragile” property of connected networks. 6 The intuition behind this result is beguilingly simple, but its implications profound. In a nutshell, interconnected networks exhibit a knife-edge, or tipping point, property. Within a certain range, connections serve as a shock-absorber. The system acts as a mutual insurance device with disturbances dispersed and dissipated. Connectivity engenders robustness. Risk-sharing – diversification – prevails. But beyond a certain range, the system can flip the wrong side of the knife-edge. Interconnections serve as shock-amplifiers, not dampeners, as losses cascade. The system acts not as a mutual insurance device but as a mutual incendiary device. Risk-spreading – fragility – prevails. The extent of the systemic dislocation is often disproportionate to the size of the initial shock. Even a modest piece of news might be sufficient to take the system beyond its tipping point. This same basic logic has latterly been applied to financial systems, using mathematical models and simulated data. 7 These knife-edge dynamics match closely the behaviour of the financial system in the recent past. A lengthy period of seeming robustness (the Golden Decade from 1997 to 2007) was punctuated by an acute period of financial fragility (the period since). The shock causing this tipping point to be reached – the sub-prime crisis – was by global financial standards rather modest. The robust-yet-fragile property of networks helps make sense of these non-linear financial dynamics.
As a result, the structure of the euro area financial sector is changing. In 2008, total assets held by investment funds were only 15% of banking sector assets. In 2017, euro area investment fund assets had grown to 42% of total banking sector assets, amounting to EUR 12 trillion. This major growth in relative size is likely to have far-reaching implications for the ability of the financial system to absorb shocks and for the financing of the economy more broadly. On the positive side, an increase in market-based finance through the issuance of debt and equity instruments can help diversify the funding base of the real economy. It also gives investors more choice and enables them to benefit from diversification effects offered by investment products. This holds true for retail and institutional investors alike, as an increasing share of institutional investors are using professional asset management services. The growing share of investors outside the core financial system tends to increase the system’s risk-bearing capacity, as traditional end-investors, typically not leveraged, can absorb any potential losses more smoothly. One should also acknowledge that thanks to significant efforts in the last ten years, investment funds in the EU are subject to an enhanced regulatory framework.