Systemic Risk – Draft Article III

This is the third in a series of articles I am writing with my co-author on Systemic Risk - a hot topic, for sure! Below is the Executive Summary and the first page, which looks at definitions of systemic risk. Thought it might be helpful for some of my readers. Feedback welcome, of course!

Systemic Risk – A pragmatic starting point

Executive Summary
In the wake of the global financial collapse of 2008, governments and institutions are rethinking their approach to risk management, and specifically, systemic risk. Systemic risk is the risk that an event, or series of events, will cause the collapse of an economy or financial system. Recent reports issued by several governments have focused their recommendations on ways to better evaluate systemic risk and manage the potential for catastrophic events across the financial markets. But key to understanding and evaluating factors that may cause systemic risk is having the data to make those observations. Unreliable or inaccurate data has already been identified as a contributing factor to the collapse of the mortgage-backed securities (MBS) market, and the web of collateralized debt obligations (CDOs) that were created using the MBS. Current industry and regulatory practices do not support the level of information-gathering required to assess institutional risk, much less systemic risk. If we are to learn from our mistakes, having reliable and accurate data is a critical requirement; understanding this need is a first step.

What is Systemic Risk?

"I think that the Fed probably performed better than most other regulators prior to the crisis taking place, but I think they’d be the first to acknowledge that in dealing with systemic risk and anticipating systemic risk, they didn’t do everything that needed to be done," US President Obama. [1]

Over the past six months, the phrase “systemic risk” has been used by politicians and regulators around the globe in discussing their response to the global financial crisis that erupted in 2008. Governments are now proposing new approaches to managing risk, and references to “assessing systemic risk” are frequently included as an important component to those proposals. But even as recent government reports from the United Kingdom, the European Union and the United States stress the need to address “systemic risk,” there is no shared definition of this risk.

One of the more cogent studies we have found lists three definitions of systemic risk frequently used by banking institutions:

1. A “big” shock or macro-shock that produces nearly simultaneous, large, adverse effects on most or all of the domestic economy or system.

2. An event that sets in motion a series of successive losses along a chain of institutions or markets comprising a system (the domino effect).

3. An initial, exogenous external shock that causes spillover, but does not involve direct causation and depends on weaker and more indirect connections.[2]

The second definition above is generally consistent with that of the US Federal Reserve (the Fed). Likewise, the Bank for International Settlements (BIS) defines systemic risk as “the risk that the failure of a participant to meet its contractual obligations may in turn cause other participants to default with a chain reaction leading to broader financial difficulties” (BIS 1994, 177).

The existence of three definitions points out the difficulty of managing systemic risk, in that there may be no consensus for what possible event government regulators or institutions are preparing, and therefore what data needs to be collected to conduct their supervision. Having a common understanding of what is systemic risk is a prerequisite to knowing what data collection is necessary to manage that risk.

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[1] Labaton, Steve, “Behind the Scenes, Fed Chief Advocates Bigger Role,” New York Times, 6/23/09

[2] “What is Systemic Risk, and Do Bank Regulators Retard or Contribute to It?” George G. Kauffman & Kenneth E. Scott, The Independent Review, v. VII, no. 3, , Winter 2003, at 371.