Managing Systemic Risk in Legal Systems

ions and musings to deep philosophical insights and formal mathematical ideas, see generally NASSIM NICHOLAS TALEB, THE BLACK SWAN: THE IMPACT OF THE HIGHLY IMPROBABLE (2d ed. 2010). Although Taleb seems at times to claim discovery of the novel perturbation problem, the idea has been at the core of complexity science since its inception, see MURRAY GELL-MANN, THE QUARK AND THE JAGUAR: ADVENTURES IN THE SIMPLE AND THE COMPLEX 123–34 (1994), though Taleb’s work has certainly popularized and refined it. Taleb’s second edition of the book added a postscript on robustness and fragility which, while mostly rambling personal musings, contains kernels of the RYF dilemma model. See TALEB, supra, at 305–29. His latest book, on his concept of “antifragility,” is in the same vein. See NASSIM NICHOLAS TALEB, ANTIFRAGILE: THINGS THAT GAIN FROM DISORDER (2012). But see N.N. Taleb & R Douady, Mathematical Definition, Mapping, and Detection of (Anti)Fragility (Aug. 2012), available at http://ssrn.com/abstract=2124595 (developing a dense, formal model of antifragility, the property of increasing robustness to volatility). Although I enjoy and recommend reading Taleb’s work, and it is chock full of wonderful examples and insights, I find it difficult to extract a coherent theory, likely because Taleb 588 INDIANA LAW JOURNAL [Vol. 89:559 The second reason is what I will call the shifted risks problem. Investment in one type of fail-safe strategy might enhance its contribution to robustness but shift more risk to other fail-safe mechanisms not yet ready for the challenge because their fragilities had been masked by the previous failures of the now-improved component. In the levee example, this could happen if the levee walls are raised in one area to stop frequent spillovers, but then downstream areas are revealed to be unprepared to receive higher flood levels that result as the high water is funneled downstream. Their fragility was masked by the fragility of the upstream levee. The third reason is what I will call the failure cascade problem. As system organization becomes more complex, even slight perturbations could have cascading and ultimately catastrophic consequences through the tightly interconnected system. A sensor malfunction, for example, could send the wrong feedback signal to a system actuator that then sets off a chain of miscued signals down multiple connected feedback chains. In the levee example, if based on erroneous information an upstream floodgate operator takes the wrong action—say, by releasing too much floodwater—the effects can literally flow downstream to trigger actions and consequences of vast proportions. Finally, there is what I will call the spillover effect problem. Adding a fail-safe strategy into the system could prove highly effective at addressing the target problem, but doing so also necessarily alters the system architecture. This reconfiguration could possibly have unintended effects at seemingly distant or unrelated places in the system, effects that expose a previously unknown fragility. For example, building a levee system to withstand earthquakes, to manage river levels along the entire river, and with improved information sources very well might reduce flood damages, but it also may induce people and businesses to move into the floodplain so that when a failure does occur it actually imposes vastly higher damages. The result of novel perturbations, shifted risks, failure cascades, and spillovers is the paradox that the “control systems are the primary source of RYF in complex systems, since the same systems that provide robustness under normal operating conditions can yield extreme fragilities if they fail or are hijacked.” Fragility is, in this sense, an emergent property: Taken alone, every fail-safe strategy might openly purports to disdain theory. To be sure, overtheorization is of little practical value, but undertheorization has its downside as well—observations without theory are just observations. 133. Alderson & Doyle, supra note 1, at 842. Alderson and Doyle observe, for example, that enhancements in ultraquality computer hardware have shifted fragilities from hardware failures to software issues, such as exposure to viruses. 134. This kind of upstream-downstream tension is rampant in flood control and frequently leads to litigation, a current example involving federal government decisions regarding management of the 2011 Mississippi River flooding. See, e.g., Quebedeaux v. United States, No. 11-389L, 2013 WL 4479834 (Fed. Cl. Aug. 20, 2013); Big Oak Farms, Inc. v. United States, 105 Fed. Cl. 48 (2012). 135. Alderson & Doyle, supra note 1, at 843. The cascade effect is a major study focus in ecology and ecosystem management sciences. See CHRISTENSEN ET AL., supra note 24, at 672 box 4 (“Trophic cascades are striking illustrations of the links between population dynamics and ecosystem processes.”). 136. Alderson & Doyle, supra note 1, at 843. 137. Id. at 842. 2014] MANAGING SYSTEMIC RISK 589 seem beautifully designed to handle its discrete target problem, but fragility nonetheless emerges from the system of fail-safe strategies. Adding yet more fail-safe mechanisms when the control system fails thus only adds to the emergent effect. As Alderson and Doyle explain: [T]he emergence of complexity can often be seen as a spiral of new challenges and opportunities that organisms and/or technologies exploit, but which also lead to new fragilities, often from novel perturbations. When successful, fragilities are met with increasing complexity and robustness, which, in turn, creates not only new opportunities but also new fragilities, and so on. Managing or, ideally, preventing this “RYF complexity spiral” remains a central challenge in engineering, medicine, and human society. This RYF complexity spiral effect goes far in explaining what has in other contexts, particularly that of the financial sector, been referred to as “systemic risk.” Although there is no universal definition of financial systemic risk, two leading scholars on the topic, Iman Anabtawi and Steven Schwarcz, adopt one that captures the core problem: [T]he risk that (i) an economic shock such as market or institutional failure triggers (through a panic or otherwise) either (X) the failure of a chain of markets or institutions or (Y) a chain of significant losses to financial institutions, (ii) resulting in increases in the cost of capital or 138. Id. (footnote omitted). Cast at a much larger social scale, archaeologist Joseph Tainter’s work on societal collapse in which he postulates, based on extensive research on past societal-scale collapses, that social systems become more complex as they solve successive problems, and that eventually bearing the load of this increasing complexity itself becomes a problem requiring problem solving, which yields yet more complexity, and so on. Eventually the net benefit of more problem solving (i.e., of more complexity) becomes negative, and the society spirals into collapse. See JOSEPH A. TAINTER, THE COLLAPSE OF COMPLEX SOCIETIES (1988); Joseph Tainter, Social Complexity and Sustainability, 3 ECOLOGICAL COMPLEXITY 91 (2006). Tainter’s work has been profoundly influential, particularly in its challenge to the idea that so-called sustainable development is a possibility. See Karl W. Butzer, Collapse, Environment, and Society, 109 PROC. NAT’L ACAD. SCI. 3632 (2012) (without mentioning Tainter, arguing that past societal collapses are most attributable to incompetent governance, war, and pestilence, and that modern states are more equipped to handle these forces and thus less subject to collapse); Samuel Alexander, Resilience Through Simplification: Revisiting Tainter’s Theory of Collapse (Simplicity Inst. Report 12h, 2012), available at http://ssrn.com/abstract=2095648 (challenging Tainter’s gloomy conclusion that sustainable development is not sustainable, arguing that “voluntary simplification” can reduce the complexity burden). In any case, Tainter’s work is not focused on the local shocksystem failure problem of systemic risk taken up next in the text and which is my primary concern, so I do not weigh in on the explanatory value of his theory. On the other hand, if there is anything to Tainter’s theory, high systemic risk—that is, small shocks frequently leading to cascading failures in law and other social systems—is likely one indicia of a society passing the collapse tipping point he describes. 590 INDIANA LAW JOURNAL [Vol. 89:559 decreases in its availability, often evidenced by substantial financialmarket price volatility. In less formal terms, they describe systemic risk as the propensity of the system “to transmit a localized adverse economic shock throughout the financial system, amplifying it in the process.” Importantly, systemic risk theory emphasizes that it is not the size of the shock that matters most in triggering such a failure, as “even small random fluctuations may lead to full cascades if critical conditions are met.” Rather, “systemic risk depends much more on ingredients such as the network structure, the safety margin and threshold distribution.” The shock matters, but system organization matters more. Indeed, “[t]he threat is complexity itself.” Legal scholars dating back to the 1980s have written about systemic risk in financial systems, but the recent global financial crisis has spawned a plethora of work on the topic focused on understanding system-wide effects. In their most recent work, for example, Anabtawi and Schwarcz develop a theory of the mechanisms of systemic risk. Although they do not adopt a complexity science model to explain these mechanisms, they do identify what they call the complexity of the financial system as being a result of, among other things, its structure as “a complex ‘network’ comprised of institutions, or ‘nodes,’ that are both interconnected and interactive.” They dig deeper into financial system complexity, discussing the many ways in which the institutions are connected and the feedback effects that can lead to a “domino model of contagion.” Another legal scholar working on systemic risk in the financial system, Lawrence Baxter, more rigorously employs complexity science to explain the system’s increasing complexity and the resulting exposure to fragility and cascading failures. 139. Anabtawi & Schwarcz, supra note 11, at 1353 (alteration in original) (quoting Steven L. Schwarcz, Systemic Risk, 97 GEO. L.J. 193, 204 (2008)). 140. Id. at 1355–56. 141. Claudio J. Tessone, Antonios Garas, Beniamino Guerra & Frank Schweitzer, How Big Is Too Big? Critical Shocks for Systemic Failure Cascades, 151 J. STAT. PHYSICS 765, 765 (2013). 142. Id. at 782; see also MITCHELL, supra note 6, at 255–57 (explaining system form as the channel for cascading failures). 143. MITCHELL, supra note 6, at 257 (internal quotation marks omitted). 144. See, e.g., Helen A. Garten, Regulatory Growing Pains: A Perspective on Bank Regulation in a Deregulatory Age, 57 FORDHAM L. REV. 501, 560–61 (1989) (“[T]he goal of bank regulation, to prevent losses to the banking system as a result of bank failure, makes the regulatory system overinvested in particular banks whose failure poses systemic risks.”); Michael Gruson, The Global Securities Market: Introductory Remarks, 1987 COLUM. BUS. L. REV. 303, 308 (“What we should be concerned about is systemic risk—the risk arising from the systems of the international market as such—not the risk which relates to the individual investor or even an individual institution. Given the size of today’s predominant financial players, the failure of one could affect the whole market.”). 145. Anabtawi & Schwarcz, supra note 11, at 1371. 146. Id. at 1371–72. 147. Lawrence G. Baxter, Betting Big: Value, Caution and Accountability in an Era of Large Banks and Complex Finance, 31 REV. BANKING & FIN. L. 765, 852–68 (2012); see 2014] MANAGING SYSTEMIC RISK 591 Although not framed in the lexicon of the RYF dilemma model, much of what these legal scholars have to say resonates in Alderson’s and Doyle’s lament that “almost nothing appears sustainable in the long run, and catastrophic cascading fragilities seem increasingly commonplace.” What is largely missing from the legal scholarship on systemic risk in the financial system, however, is an appreciation of the RYF complexity spiral and law’s role in it. Anabtawi and Schwarcz, for example, position their work as identifying the financial system failures that led to the crisis and aim to “show that government can disrupt the transmission of systemic risk by addressing these failures.” Much of their work is devoted to proposing “policy tools for correcting such failures.” This is all well and good—it has to be thought about—but as the RYF dilemma model shows, it must be thought about with the RYF complexity spiral in mind, and not only for the financial system, but also for the legal system. In other words, as we invent and implement regulatory fail-safe measures are we unwittingly feeding the RYF complexity spiral not just in the financial system, but in the legal system as well? With the exception of Baxter—who may be the exception because he uses a complexity science perspective—legal scholars of systemic risk do not anticipate this paradox. Baxter, however, recognizes that the many problems he and others identify in the structure of the financial system are just the tip of the iceberg: [T]he problem is even deeper and more paradoxical because an additional dimension of complexity has also begun to manifest itself in the form of “regulatory complexity.” Regulatory complexity stems not only from the huge volume of new regulations and regulators being hurled at the financial industry in an attempt to reduce the risk of financial instability, but also from the inherent contradictions in our public policy objectives, overlaps in agency missions, and the ebb and flow of political accountability that applies to regulators. also Manuel A. Utset, Complex Financial Institutions and Systemic Risk, 45 GA. L. REV. 779 (2011) (emphasizing interconnectedness); Dimitrios Bisias, Mark Flood, Andrew W. Lo & Stavros Valavanis, A Survey of Systemic Risk Analytics (U.S. Dep’t of Treasury Office of Fin. Research, Working Paper No. 0001, 2012), available at http://www.treasury.gov /initiatives/wsr/ofr/Documents/OFRwp0001_BisiasFloodLoValavanis_ASurveyOfSystemic RiskAnalytics.pdf (although not explicitly adopting a complexity science analysis, detailing the numerous interconnected components of the financial system leading to systemic risk). 148. Alderson & Doyle, supra note 1, at 843. 149. Anabtawi & Schwarcz, supra note 11, at 1352. 150. Id. at 1381. 151. See Baxter, supra note 147, at 863–64 (footnotes omitted). Lynn Stout has more directly blamed legal failure—specifically, an obscure 2000 federal statute changing the rules for derivatives trading—for the financial system crisis, concluding that “the credit crisis was not due primarily to changes in the markets, it was due to changes in the law.” Lynn A. Stout, The Legal Origin of the 2008 Credit Crisis, (UCLA Sch. of Law, Law-Econ Research Paper No. 11-05, 2011), available at http://ssrn.com/abstract=1770082. Although I do not have sufficient expertise in financial system regulation to evaluate claims like this, it is perfectly consistent with the RYF model that relatively minor tinkering within the complex financial regulatory system could lead to a cascade of failures. 592 INDIANA LAW JOURNAL [Vol. 89:559 Although Baxter does not develop the idea further, he clearly is on to something if one puts any stock in the RYF dilemma model. As I have suggested above, the legal system is in essence a social system for producing fail-safe mechanisms to manage systemic risk in other social systems (and within law). As Baxter suggests, the paradoxical effect of “hurling” these fail-safes without attention to their complexity effects can be to add to rather than decrease systemic risk. But even his focus is on how these regulatory fail-safes affect systemic risk of the other systems, whereas my focus is on their effects on systemic risk in the legal system. Given the root cause of systemic risk, there is no reason to believe that the financial system is alone among social and economic systems in being susceptible to systemic risk, or that the legal system is immune to it. Some level of systemic risk is present in all complex adaptive systems, and the legal system arguably is as tightly interconnected and interdependent as any other. So when we invent regulatory fail-safes and “hurl” them at other social systems, we must also be mindful of managing their effects on the legal system that produced them. 152. See supra Part IV.A. 153. See Baxter, supra note 147, at 863–64. In their study of railway disasters, Lloyd Burton and M. Jude Egan describe the “hurling” response that often follows railway accidents as “reactive legislation, which will once again lead to reactive regulation.” Lloyd Burton & M. Jude Egan, Courting Disaster: Systemic Failures and Reactive Responses in Railway Safety Regulation, 20 CORNELL J.L. & PUB. POL’Y 533, 550 (2011) (emphasis omitted). 154. Similarly, Aviv Pichhadze has developed a theory of “regulatory systemic risk” that “arises from long-term imbalances that result from regulatory initiatives that are premised on a distorted understanding of market realities.” Aviv Pichhadze, Regulatory Systemic Risk in US Securities Regulation, LAW & FIN. MARKETS REV., May 2011, at 176, 176. While potentially an important observation for understanding financial market failure, the problem he identifies is not about systemic risk in the regulatory system itself, but how poorly designed regulatory systems—that is, ones not aligned with “market realities”—can contribute to systemic risk in the financial system. Good alignment with “market realities,” however, will not necessarily eliminate systemic risk in the regulatory system; indeed, it could increase or decrease legal systemic risk depending on how the regulatory system is designed to align with the market systems. 155. My brother and I suggested a dynamic something like the RYF complexity spiral at work in the legal system in an article we published many years ago. See J.B. Ruhl & Harold J. Ruhl, Jr., The Arrow of the Law in Modern Administrative States: Using Complexity Theory to Reveal the Diminishing Returns and Increasing Risks the Burgeoning of Law Poses to Society, 30 U.C. DAVIS L. REV. 405, 461–67 (1997). We argued that a new law might respond adequately to its target policy problem, but that spillover effects could generate other social problems, thus triggering new law initiatives, and so on into a “cycle of law” that builds “structural complexity” which, if the cycle runs unabated, “reaches levels of interconnectedness and intensity that pose the problem of increasing vulnerability to collapse.” Id. at 456, 467. Complexity science was nascent at the time, and our model leaned heavily on anthropological theory—for example, TAINTER, supra note 138. Having the benefit of over a decade of advancements in complexity science, I find the RYF model a more complete theoretical home for examining the spiral toward increasing complexity in legal systems. 2014] MANAGING SYSTEMIC RISK 593