Systemic Risk - An Historical and Prescriptive View

President Obama (wow, still have to think about that when I write it) today issued recommendations for changing the way the financial markets are regulated, in response to the collapse of the financial markets last Fall. One goal of the proposals is to address the management of systemic risk ("Improve tools for managing financial crises"). My co-author Bill Nichols and I have already spent some time thinking about this topic, and are in the midst of writing up a series of short articles addressing various questions that we think are raised by the concept. Below are the introductory paragraphs from the draft of our first article, looking at the way risk has been managed historically.

* * *

The collapse of the financial infrastructure last year has caused both regulators and institutions to reassess their approach to risk management, and specifically, how they address systemic risk. Prior to 2008, few, if any, in the financial industry thought the assessment of systemic risk necessary – in fact, it was a commonly held belief that the world markets were not inter-connected (despite abundant evidence to the contrary). But the collapse of the housing industry in the U.S. and its domino effect on global markets as far away as China, on the portfolios of countries such as Iceland, and on the investments of small towns such as Perth, Australia, has woken up managers and regulators across the industry to the importance of understanding and accounting for systemic risk.

The US government’s inability to comprehend the magnitude of the risk of the CDS and CDO market that grew explosively based on mortgage-backed securities of questionable quality was clearly a major impediment to the appropriate regulation of that market. A better awareness of that market and its possible impacts on the rest of the economy, that is, the risk of its effects system-wide, may have allowed our government to better anticipate and regulate the underpinnings of that market.

The United States’ widely-held reputation as the best regulated market in the world has been severely damaged by the financial crisis, but blame for the collapse is not to be placed only on the failure of US regulators; countries across the EU as well as officials in China and Japan, did not adequately monitor the inter-related investments being made across borders. But, frankly, there was no way for regulators to have a view of systemic risk across borders – there were not then, and are not now, the analytical frameworks with their requisite information protocols , or the software systems in place to be able to make such an assessment.

If the financial collapse of 2008 is not to be repeated, regulators need information to be able to see and make judgments about new products and relationships as they emerge among market participants, to make intelligent decisions about how to evaluate and manage systemic risk. We have the tools available to make those judgments, but the technology and data management practices currently utilized in the industry do not permit a coherent systemic overview of investment behaviors. We have created a technical problem, in that we have neither planned nor budgeted for the specific structural requirements that will enable regulatory oversight. Until decision-makers have an understanding of the technology and work with those who know it best to maximize its contributions to risk management, we run the risk of falling prey to the same recurring crises in the future.

* * *
Comments welcome.