Thursday, March 18, 2010

What is systemic risk anyway?

Further definition with some help

First, let’s set some limits on the two leading candidates, leverage risk and aggressive speculation. They play an important role in macroeconomics. Thus, it isn’t surprising that they crop up in a discussion of systemic risk. Hopefully, we can establish their role without a full blown macroeconomic discourse.

Often, the implicit assumption built into the discussion is that leverage is the primary source of systemic risk. That is a reasonable argument. Everybody now knows that leverage is a source of risk. That’s true even if a lot of people forgot it for a while, and even though some politicians believe that the government is above such mundane risks.

Joseph Schumpeter of “creative destruction” fame built his theory of business cycles around technology cycles and financial cycles (basically leverage cycles). There was also a very good academic paper on leverage cycles published a few years ago. It had a very concisely constructed model. Regrettably, I lost it. Generally, but not always, I’ll reference books, web sites, and current periodicals rather than “the literature.” They are harder for me to lose as well as easily accessible to interested readers. Besides, in this case, Schumpeter’s book BUSINESS CYCLES is still one of the better reads on the issue.

One can’t dismiss the role of leverage. Capital requirements, moving derivatives to exchanges, and margin requirements are some of the responses discussed in various postings. Are they enough? Note that this is a business cycle theory. A business cycle may or may not create systemic risk. Leverage has been treated as a “necessary, but not sufficient” source of systemic risk. Granted, little has been said to justify even saying it is necessary. But, if the reader does think leverage creates risk, my advice is to run for national office. You will find a set of fellow believers.

Keynes turned to “animal spirits” to explain risk cycles and their role in business cycles. We now live in a world where an individual can start a hedge fund or private equity fund and gear up the leverage to phenomenal levels. They can do it by borrowing or through the instruments they trade. That’s aggressive speculation based on leverage. Clearly, the two are related. In fact, measuring leverage is a valuable tool for measuring risk appetites.

However, leverage isn’t the only expression of risk appetites, nor is it the only risk. Some of the players seek out risk in the form of volatility. They then bet on it in various ways. Trying to arbitrage even minor anomalies is one. Another is to make directional bets. There is also a fairly reasonable argument that seeking asymmetric returns is an expression of risk seeking, although the entire discussion of asymmetric returns hinges on assumptions about the marginal utility of money. But, we are still only dealing with business cycles.

Perhaps the best way to address “animal spirits” is as “a necessary, but not sufficient” source of systemic risk. However, an implicit assumption in a number of the discussions of various proposals has been that judging the right risk appetite over time is hard, if not impossible. Ignoring that fact is a dangerous form of hubris. During good times, taking risks seems like a good bet --“pour on the risk!” When thing get shaky, being conservative looks smart. Behavior economists are having a field day with that fact right now.

Another assumption that needs to be made explicit is that changes in risk appetites are more important than the absolute level of risk taking. That view should color one’s attitude toward proposals. But, we are still talking about business cycle risk. So, a logical question is: what is different about systemic risk?

It’s time to put leverage and risk appetites them in context. Summarizing the discussions in previous postings, debt markets were the source of the crash. It went way beyond being an indicator. There was a lot of reckless borrowing and lending. Once debt markets realized how many people weren’t going to pay back their borrowing, debt markets froze. It started with mortgage debt, but spread via the shadow banking system. The liquidity needed to adjust for the mispriced Mortgage Backed Securities rippled through every market in the shadow banking system. One way to describe what happened would be that mispriced MBS debt morphed into mispriced liquidity. Any market, and therefore, any organization with a liquidity mismatch became vulnerable. That transformed a liquidity-driven contraction into a generalized fear about counterparty solvency.

Granted, that’s a simplified summary, but a complete discussion would be a book and there are plenty of them. Besides even at this level of generalization, the summary illustrates my point. Systemic risk almost has to include the potential for common mode failure, event failure, and cascade failure. Viewed from that perspective, every proposal for regulatory reform is right if it addresses one of the risks. Similarly, every individual proposal is wrong if taken in isolation.

So, how does The Hedged Economist weight these different risks of failure? Just in the interests of disclosure, let me advance the argument that cascade risk is the one that is most systemic; not necessarily the origin of the risk, but the one that makes it systemic. That said, one doesn’t have to pick. That’s good because it isn’t an opinion I’d want to have to support.

If one can argue that one factor can influence all three types of risk, picking becomes unnecessary. Some readers may want to say: “if it’s common to all three, it’s a risk of a common mode failure.” OK, but I think that overstates the case.

In any case, in addition to talking with regulators as discussed in a previous posting, between 2003 or 4 and recently, The Hedged Economist spent time talking to risk management professional in the financial service industry. My thesis was that they were mismeasuring financial risk. Given that experience, rightly or wrongly, it is natural that the frustration of that experience makes it loom large.

It’s possible that everything I said during that period was wrong, irrelevant, or impractical. But, if people were systematically mismeasuring risk, it would affect all three types of risk. So, with this posting, the focus will shift from risk regulation to risk measurement, hedging and investing. They are more interesting topics, and as argued above, more important.


  1. Hello, Hedged: Your former colleagues at MEDC would like to invite you to cross-post some of your thoughts to our LinkedIn Discussion Group. To participate you just need a LinkedIn account; get in touch if you need instructions or info. All the best,

    Andy Cassel

  2. I just came across an excellent discussion of the leverage cycle at . It worth reading if you’re new to the idea of credit cycles.