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November 06, 2009

What is systemic risk, anyway?

On October 30, the Center for Financial Innovation and Stability at the Federal Reserve Bank of Atlanta held a conference on Regulating Systemic Risk. The presentations mostly focused on the recent financial crisis and possible regulatory responses to those developments.

Oddly enough, the term systemic risk hardly came up even though it was a major part of the conference's title. Then again, maybe it wasn't so odd.

Systemic risk is a relatively new term that has its origin in policy discussions, not the professional economics and finance literature. A search of EconLit turned up the following: The first appearance of the term systemic risk in the title of a paper in professional economics and finance literature was in 1994. That appearance was in a review of a book written by a World Bank economist, not a journal article by an economist at a university.

Given its origin in policy discussions, perhaps it is not so surprising that the term "systemic risk" often is used with no apparent precise definition in mind. If it arose from a theoretical analysis as did a term it sometimes is confused with—systematic risk— there would be a very precise definition.1

The G10 Report on Consolidation in the Financial Sector (2001) suggested a working definition:

"Systemic financial risk is the risk that an event will trigger a loss of economic value or confidence in, and attendant increases in uncertainly [sic] about, a substantial portion of the financial system that is serious enough to quite probably have significant adverse effects on the real economy."

While this is a reasonable definition in terms of the concerns in mind, the precise definitions and measurement of terms such as "confidence," "uncertainty," and "quite probably" are likely to be elusive for some time, if not forever. Furthermore, the definitions probably include a lot more than what usually seems to be meant by systemic risk. For example, the risks of an earthquake, a large oil price increase, and a coup fit in this definition. Or maybe "systemic risk" should include such events?

Even George G. Kaufman and Kenneth E. Scott (2003) define "systemic risk" in imprecise terms:

"Systemic risk refers to the risk or probability of breakdowns in an entire system, as opposed to breakdowns in individual parts or components, and is evidenced by comovements (correlation) among most or all the parts."

To me, this definition is better than the G-10 definition because it does not confuse the event being analyzed (the breakdown) with the cause (the loss of confidence). Even so, a precise definition of "breakdown" may be elusive even if the term is evocative.

Darryll Hendricks (2009), who is a practitioner, suggests a more theoretical definition from the sciences in which the term originated:

"A systemic risk is the risk of a phase transition from one equilibrium to another, much less optimal equilibrium, characterized by multiple self-reinforcing feedback mechanisms making it difficult to reverse."

This definition includes many words that aren't used in everyday English and is quite abstract, focusing on the mathematics to characterize the situation. That said, this definition has a better shot at being more precise in terms of economic and financial analysis of actual situations than does the G10's definition. But the economic content of this definition as it stands is zero.

One solution is the following: Kaufman and Scott's definition is a reasonably clear, tentative definition of the term that doesn't use too many other words that require definition. Hendricks's more theoretical definition or something like it probably is a helpful start to ways of thinking about systemic risk in analytical terms.

By Gerald P. Dwyer, director of the Atlanta Fed's Center for Financial Innovation and Stability

References

Group of Ten. 2001. "The G10 Report on Consolidation in the Financial Sector."

Hendricks, Darryll. 2009. "Defining Systemic Risk." The Pew Financial Reform Project.

Kaufman, George G., and Kenneth E. Scott. 2003. "What is Systemic Risk, and Do Bank Regulators Retard or Contribute to It?" Independent Review 7 (Winter), pp. 371-91.

1In the context of the capital asset pricing model, systematic risk is the risk associated with changes in the overall stock market. It can be defined similarly in other theories of asset returns.

November 6, 2009 in Financial System, Regulation | Permalink

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Comments

Hendricks definition suffers from a problem that the concept of equilibrium tends to be stationary, but we usually talk about systemic risk as building up. For example, the run up in housing prices or the worsening of global imbalances can be viewed as dynamic triggers of systemic risk events. Perhaps such phenomena could be represented in an equilibrium model that transitions to systemic risk, but maybe not.

Posted by: csissoko | November 06, 2009 at 06:08 PM

It seems that it is necessary to distinguish endogenous systemic risk, i.e., that generated by the system itself that can lead to widespread market failure, such as excess leverage, from exogenous shock, since each requires a different approach.

Posted by: Tom Hickey | November 07, 2009 at 06:40 PM

Conspicuous by its absence in the cites is that 1994 review title by a WB economist.

Posted by: Ken Houghton | November 07, 2009 at 09:11 PM

Risk is a squeaky fan belt, systemic risk is a loud knocking sound in the engine.

Posted by: Jim Gobetz | November 08, 2009 at 10:49 AM

Systemic risk occurs when economic actors are allowed to make promises that they don't have the wherewithal to keep.

Examples:

Banks promise that you can have your money back anytime you want even though they have lent it all out.

Banks promise that you can't lose money in your account even though there's a risk that the loans they have made will not be paid back.

AIG promised to make good on bond losses (CDS) even though they did not have the assets to cover the potential losses.

Annuity sellers promise fixed payments into the future even though they have no control over the rate of return.

Defined Benefit Pension plans promise future payments that they don't have the assets to cover.

The crisis comes when these promises are revealed to be empty promises. If you want a financial system without systemic risk the solution is simple. Don't allow anyone to make promises they can't keep.

Posted by: diemos | November 08, 2009 at 10:50 PM

I don't believe in systemic risk. I think that there is transaction risk-and not priced in or accounted for correctly in models.

What are the chances that your counter party won't perform? I am sure there were folks in the Investment banking industry that said there was no way Lehman would fall. They did.

The question should be how do we mitigate counter party risk? Then when dominoes start to fall, it doesn't take down more dominoes that cause intense losses throughout the whole system.

In 2008, I don't think there was enough cash put up throughout the entire system to hold positions. Of course, because of the amount of leverage in the market, that is an easy statement to make. But even today, I think risk is underpriced in the market.

Posted by: Jeff | November 09, 2009 at 07:51 PM

The way I see you have a core and then bells and whistles. If something affects the core materially, then this is systemic. If something affects the bells it isn't, unless a bell that breaks necessarily also breaks a core.

So, then it's a matter of whats considered to be 'core'. Don't ask me, cause I don't know. Seems like land, and gold, and guns would probably involved.

I like Mr. Hendricks idea, but I wonder if the ladder can be busted down, can we also skip ahead? That is to say maybe we could learn to bust up to higher equilibriums more rapidly.

Posted by: FormerSSResident | November 10, 2009 at 12:12 PM

http://www.americanthinker.com/2009/11/why_wall_street_isnt_main_stre.html

On a tangential note, here are some things that they could do to stem systemic risk, and make the playing field more competitive.

Posted by: jeff | November 14, 2009 at 12:09 AM

Don't forget SYSTEMIC RISK: Fannie Mae, Freddie Mac and the Role of OFHEO www.fhfa.gov/webfiles/1145/sysrisk.pdf

Posted by: Jim A. | November 16, 2009 at 09:54 AM

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