Individual Advantages as a Cause of Systemic Weakness, a Parallel in Biodiversity

BBC News reports of a study that comes to a conclusion that increased nutrients decrease biodiversity by letting the fastest growing plants grab all the sunlight, while slower growing species suffocate. In a more nutrient-constrained environment, plants that use nutrients efficiently succeed alongside plants that make effective use of light. (Hat tip to Yves Smith)

I think this is a more general game-theoretic phenomenon: the higher the number of binding constraints there are in a system, the higher the number of successful strategies. The individual constraints can be seen as objectives for a multi-objective optimization problem, thus controlling the degrees of freedom in the world of Pareto-optimal solutions.

I have been thinking of the role that this phenomenon has had on the financial world. Before 1980's, the financial world was comfortably resting on limits of liquidity, in the form of binding reserve requirements, and leverage, in the form of binding limits of bank capital.

After removing the important constraint of reserve requirements, especially after 1994, when retail sweep programs were allowed, leverage has been the only major remaining limit, and was thus taken to the maximum.

After the weakening of even that limit, by changes in rules and active avoidance of regulations, actual solvency is now the only remaining factor to limit the growth of financial institutions. This is not a good limiting factor for a system built mostly of institutions that are “too big to fail”.