Belmont Club

Systemic risk

Richard Bookstaber of Seeking Alpha describes the tasks which face any regulator of systemic risk. Systematic risks are those which threaten to collapse a whole financial market, as opposed to a single firm acting within it. Bookstaber argues that the main driver of financial systemic risk is leverage or “borrowed money”. And maybe nobody was watching the overall situation as carefully as should have been. While individual firms may understand their own position, they don’t have the information necessary to assess the level of leverage the whole system bears. Everyone may have been minding the store, but nobody in particular was managing the mall.

Thus, success in managing systematic risk depends in part on the availability of the right overall information.  But information is not enough. Managing systematic risk isn’t just an MIS problem. The key failure behind the last meltdown was the distribution of responsibility. There were ample signs that the leverage had built up to dangerous levels. But the responsibility for acting had gravitated to a level where inaction was guaranteed. Bookstaber writes:

It was not the malfunction of sophisticated risk models or some 100-year flood that swamped the risk controls, it was a huge and unrelenting inventory buildup of illiquid and often complex securities — a buildup that was there to be seen and corrected. How did so many people miss this elephant in the room?

One likely factor is that the problem was passed up the chain of command until it got high enough to be ignored. In other words, the risk management failure within the banks was largely organizational; it had to do with incentives, lack of communication and plain old-fashioned bureaucracy.

The ultimate systematic risk is the failure of leadership, either because decisions aren’t made or can’t be made at the levels they are taken to. Fixing the system means repairing the links between those who stand to lose and those who must act. In other words, the chain of responsibility and accountability has to be reconnected.

To deal with this potential source of failure, the systemic-risk regulator must have direct lines of communication to the chief risk officers of major financial institutions. The regulator can act as the CRO’s ombudsman, an outside voice with the power to get things done if the risk officer’s own voice is not being heard within the firm. Having a link with the CROs of major banks and hedge funds would also allow the systemic-risk regulator to discern “flavor of the month” strategies and instruments that might portend crowding.

It’s our old friend the principal-agent problem again in another guise. In bureaucracies in which rocking the boat becomes the ultimate crime, the incentives for doing nothing become overwhelming. As the debt bubble expanded, many people could see the danger. But perhaps none of those who could actually do something about it were sufficiently threatened to risk blowing the whistle and stopping the show.

The real danger, to my mind, in proposals to create even more levels of regulation is that it may finally result in a situation where everybody is responsible for everything and consequently, nobody is responsible for anything. Unaccountable bureaucracy may be the ultimate systemic risk.


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