The Systemic Risk Challenge

I am a member of a group with the mission of analyzing and discussing the new financial reform laws and proposed global capital standards for the banking system. Obviously there is substantial amount of material for our newly-formed group to dissect.

As we closed out our first meeting, a group member posed a question about the identification of escalating “systemic” risk, specifically referencing whether it is possible to preemptively identify such risk “pre-boiling point” in order to wind down the activities and prevent a widespread impact on our economy.

What is driving this question? In a summary of the financial reform bill published by the Senate Committee on Banking, Housing, and Urban Affairs, one finds this statement:

“The newly created Financial Stability Oversight Council will focus on identifying, monitoring and addressing systemic risks posed by large, complex financial firms as well as products and activities that spread risk across firms. It will make recommendations to regulators for increasingly stringent rules on companies that grow large and complex enough to pose a threat to the financial stability of the United States.”

Though I have a few more weeks to seriously consider my perspective on the issue, my immediate reaction to the question is that though noble in aim, such risk mitigation will be nearly impossible – especially for a council composed of government regulators. I believe this simply because it has been the long-standing aim of a multitude of government entities to identify and reduce risk, or at least the impact of risk. The efforts have not proven to be as effective as hoped for.

One of the reasons is that often government has competing ideals. Consider the desire to increase homeownership rates and lending to underserved areas and the desire to keep people in these areas from being “harmed” by the loans they take on. Consider the desire to be the leader in space flight and exploration and the desire to do so without harm to astronauts. The list goes on.

When economic/market ideals compete, consensus on risk and limitations is hard to come by, which means a group such as the Financial Stability Oversight Council will likely have difficulty in proving a specific activity poses enough of a risk to be curtailed. I wonder what such a group would say about the computer trading-inspired “flash crash” of this past summer. Do such activities pose systemic risk? It appears they could so curtailing these activities would seem a sound recommendation in terms of protecting markets from undue volatility and the potential for a crash.

But, there is another side. Waddell & Reed, the firm believed to have executed the trade that triggered the crash, stated that it had sold certain contracts to reduce its funds’ risk quickly. If a company’s (or industry’s) ability to reposition a portfolio to change its risk concentration is limited, does that not also serve to increase risks to the market and economy?

I’m no Wall street expert. The closest I come to insider knowledge of the ins and outs of Wall Street is what I gleaned from watching Wall Street 1 and 2 – two movies that hardly lead to professional qualification. However, even if my reflection on this example is a bit off the mark in terms of Wall Street plumbing, it does illustrate the challenge of gaining clear enough consensus amongst government regulators that one firm, a specific activity, or a particular product poses a systemic risk in need of curtailment before that firm/activity/product does harm. This also leads to my next point.

Another reason systemic risk identification and mitigation will prove challenging is that government (politicians and regulators) are often behind the creative arc of the entities they are regulating. Thankfully ours is a country where our creative efforts are not solely defined by the laws on the books. Americans explore uncharted territories. We tinker. We invent. Unless the government gets into the business of prescribing invention down to schematics, government regulators will always be one step behind the inventors.

This is not to say that government, or our regulatory institutions, are full of less-than-intelligent people. Some of the smartest people I know have plied their trade in service to government agencies. Rather, it is simply the fact that unless a regulator “knows all” to begin with, they never will know all when it comes to the business of those they regulate. This, to me, means that the Financial Stability Oversight Council will not be certain about many of the activities or firms that pose systemic risk until after the activity or firm proves to be a risk through a profound negative impact on the economy.

My fear, then, is that such a group ends up in the same class as those I lumped into my “efforts have not proven to be as effective as hoped for” comment earlier in this post. I see this unfolding as something of a modern-day Goldilocks story, with the effort to find solutions ending up as either too cold or too hot and seldom “just right.”

If the systemic risk challenge is met with efforts that are too cold, that is efforts not far-reaching enough, then we will be here, in the throes of debate on proper reform, yet again.

If the effort is too hot, that is firms, activities and products are unduly restricted because of overreaching response to perceived risk, then we will see our competitive advantage in financial innovation gradually dwindle as the talent in our financial community finds better opportunity elsewhere.

Although, now that I think about it, it may be perhaps the “just right” scenario that is the most disturbing. We “identify” the risks, “solve” the problem, and then take a nice nap – only to be awakened by a group of hungry bears the likes of which we didn’t even consider in our assessment of risk.

Though in the next few weeks my opinion may change, for now I believe that systemic risk is something that, unfortunately, we can only know after we see its broad and negative impact.


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