Systems Thinking with Causal Loop Diagrams

A Systems Perspective on the Financial Crisis of 2007–2008

Let's consider the 2007–2008 financial crisis and imagine we can talk to experts in the field. You could ask them to identify some of the main ‘ingredients’ involved in what happened. They might explain these were (1) the property market, (2) the availability of easy credit (via sub‑prime loans/mortgages) and (3) how mortgages were turned into securities.

Then, you could then ask them to explain the links between these ingredients and add some others, such as (I) credit ratings standards, (II) the amount of capital to loans for each bank (i.e. ‘leverage’) and (III) processes used to assess any risks.

You could also ask the experts to explain the key risks that might arise from all these elements or systems. They might explain they were (i) the complexities of turning mortgages into securities, (ii) potential errors in risk assessments for liquidity, (iii) how the rules worked around bank balance sheets (e.g. the levels of ‘leverage’ allowed.), etc.

Already, you could easily feel overwhelmed; but when you start thinking about systems, I advocate avoiding getting drawn into an Alice in Wonderland world of complex explanations and words you may not understand. Instead, I recommend a KISS approach, where you see all the building blocks in play, but that doesn't mean you need to understand every one of these in detail.16 And in the end, with the right help, you might get someone to draw out some of the key factors in the 2007–2008 crisis using a simple one‑page diagram (see Diagram 3.3).17

Of course, the causal loop diagram does not contain every factor that influenced what happened, as denoted by the boundary chosen around the diagram. However, it is a ‘starter for 10’.

Diagram 3.3 Causal loop analysis – 2007–2008 financial crisis

And we might learn that during the early 2000s a whole host of elements, decades in the making, were on an upward, positive cycle, and any problems with the financial system were thought to be theoretical. But then there was an increase in interest rates, a fall in US property prices, resulting in a cascade of problems, one after the other, at breakneck speed. A former bank CEO, reflecting on what happened, said, ‘We wondered if we broke the financial system’.18

For the purposes of this overview discussion it’s not necessary to understand Diagram 3.3 in detail but rather note how a multi‑faceted, complex set of causes and effects can be made relatively digestible when you think in terms of systems and use causal loops, revealing how ‘one thing might lead to another’.

And while Diagram 3.3 was created after the 2007–2008 financial crisis, it could have been created beforehand, because there was a clear awareness of liquidity risks and the potential for a cascade of knock‑on problems before the crisis. As Citibank's then‑CEO Chuck Prince said months before things fell apart: ‘When the music stops, in terms of liquidity, things will be complicated. But, as long as the music is playing, you've got to get up and dance’.19

And so, we have a relatively straightforward illustration of

• why it's problematic to say the 2007–2008 financial crisis arose because of just one, or even two or three, root causes,
• how it would have been possible (and was possible) to predict much of what might happen before the full scale of problems arose 20 and
• why, after the crisis, so many aspects of financial services customs and practices and regulations, and regulatory oversight had to be changed?21

To reiterate, this book isn't a detailed ‘how to’ guide on systems thinking or causal loops. Instead, I hope I have illustrated that looking at things this way can provide a means to talk about and begin to grasp a complex problem in a way that reading a detailed 20‑page, or 200‑page, analysis with tables of numbers might not. Of course, the 20‑page, or 200‑page, analysis may be helpful and interesting for some people and in some circumstances, but the danger is that too much complexity means most people can't engage with, contribute to, or challenge, what is being said and, perhaps most important of all, understand what is not being said.