Systemic risk involves contagion. It is the fast transmission of financial infection that makes such risk existential. Ron Rimcus shows how you can assess these super risks

Systemic risk involves contagion. It is the fast transmission of financial infection that makes such risk existential. Ron Rimcus shows how you can assess these super risks

By Ron Rimcus, CFA*

The case of Jacobellis v. Ohio went before the US Supreme Court in 1963. The question the nine justices were asked to address: Did a risqué movie qualify as obscene?

In the decision delivered the following year, Justice Potter Stewart famously rendered his opinion on pornography, stating simply, “I know it when I see it, and the motion picture involved in this case is not that.”

With so much talk of systemic risk in recent years, there is surprisingly little consensus on what systemic risk actually is. Yet many people have strong views on the topic. Investors, regulators, bankers, government officials, and others are guided by their gut feelings — that is, like Potter Stewart with pornography, they know it when they see it.

But does it have to be this way? Much of the work performed on systemic risk thus far employs models that require a stream of time series data, usually focused on the pricing of various market assets. For instance, Rodney Sullivan, CFA, Steven Peterson, and David Waltenbaugh develop a sophisticated statistical model that focuses on extreme losses and market liquidity, volatility, and default risk.

Unfortunately, they neither ask nor answer the question, What happens if these are the wrong variables to monitor? Further, what happens if they are the right variables, but the market prices them incorrectly, as it did mortgage-backed securities in the mid- 2000s?

Simply fitting a model to a given sample of data only introduces the bias that the conditions present during the sample period will be the same in the future. So, as time goes by, the model will be less and less reliable (assuming it was reliable to begin with).

All the shortcomings of our models notwithstanding, they haven’t stopped the government from monitoring and regulating systemic risk. As Mark Van Der Weide demonstrates, Dodd-Frank financial reform legislation requires regulators to identify and mitigate systemic risk. But what happens when policy itself creates systemic risk, as it did in the 2008 crisis? Can we really expect the government to identify the government as the problem? And if the government can’t identify the problem, can we expect it to identify an appropriate solution? And with vast differences in approaches to modeling and monitoring systemic risk, how can we trust that the regulators got it right?

So often in the investment business, we look for answers in quantitative models. Systemic risk is 19.2 — time to hedge! Systemic risk has fallen to 7.9 . . . Phew, we can all breathe easier now! Alas, if only it was so simple. There is a quote, often and perhaps erroneously attributed to Albert Einstein, “Not everything that can be counted counts, and not everything that counts can be counted.” Apocryphal or not, it’s true in all walks of life and certainly true in evaluating systemic risk.

For instance, what if a given country starts to abandon the rule of law? What if monetary policy leads to major misallocations of capital? What if the data you need isn’t captured in time series format? What if the buffers that exist within the financial system are slowly whittled away as players (both public and private) in the system push for growth only to find themselves approaching the end of the runway in time? What if the public fails to recognize these changes and hence is absent from security prices? These examples do not lend themselves to time series data. Nevertheless, they are enormously important.

Fortunately, these conditions can be analysed. All we need is a framework for thinking about it.

Systemic risk is the potential for a large-scale failure of a financial system during which providers of capital (depositors, investors, capital markets, etc.) lose trust in either the users of capital (banks, borrowers, leveraged investors, etc.) or in a given medium of exchange (e.g., US dollars, Japanese yen, gold, silver, etc.).

Perhaps the most important component of systemic risk is contagion: It can be passed from unhealthy to otherwise healthy institutions through a transmission mechanism. If it were not for the potential for infection, then the risk would not be “systemic” at all and we would only deal with the problems at the “micro” level institutional. The transmission mechanism is defined by the combination of leverage, interconnectedness, and safeguards in the financial system. The various players in the financial system each have exposure to the three components of systemic risk as noted in the matrix below:

Systemic Risk Matrix

Systemic Risk Matrix

As noted in the table, not all of these variables lend themselves to numerical data, but when assembled as a whole they tell a compelling story.

All of this begs the question: How big a threat does systemic risk pose to markets today?

How would you rate the level of systemic risk in the financial system today?

Poll: How would you rate the level of systemic risk in the financial system today?

We polled readers of CFA Insitute Financial NewsBrief to find out. Of the 635 respondents, 47% indicated that systemic risk is high or that a systemic crisis is imminent. A full 45% said that systemic risk is moderate (i.e., medium), while only 8% indicated that systemic risk is low.

Though there is not a single conclusive systemic risk model, respondents are expressing an uneasiness about the current state of affairs.

Intuitively, they seem to know without necessarily knowing precisely why. A framework, like that presented above, will help you connect the dots, so that when you evaluate systemic risk, “You’ll know it, when you see it.”

This content was supplied by CFA Australia/New Zealand. It was orginially posted here.

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

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Yeha! this chap is asking the right questions! Fundamentally it is economic policy that is creating the problem across the world as greed has taken root, and been supported by Governments influenced by vested interests. Can we really expect the government to identify the government as the problem? Hell no! Their egos are too big. And worse they want to make us a republic so that the last protection the average man has against their excesses, the GG's Reserve Powers, will be removed. The problem is how do we fix it?

You are mixing Global in with NZ? otherwise yes I agree. Not just Govn. One thing I have observed over the last decade or so is no Govn (or political party for that matter) wants to hear bad news (such as Peak oil) and as a result wont take steps to avoid or mitigate it as that action spoils the party and costs votes, they would rather can kick. Same with the voter though, so really we have ourselves to blame first and foremost IMHO.

You are mixing Global in with NZ? not really, but the problem is both global and local. The US, UK, Europe and Australia as jus a few all have a similar issue, of Governments being so enamoured of their own opinions that they cannot see that they are the problem.

Good piece, interesting that only 7% think the issue is very close in terms of time. Then I sold out some years back and got the timeing way wrong. So the belief from speculators that the Govn wont let the system collapse seems to be holding true, maybe it will be some years yet.

My view is with things like high speed trading when it does go wrong I think the financial collapse / lock up will be very fast like days unlike 1929.

"Chinese customers are accelerating the pace of moving assets outside China"

Then there are Steve Keen's comments on the 7 most likely countries to go badly

Methinks that when the big bang comes the stock markets will, as history guides us, be the first manifestation (they are now hyper-inflated and the most liquid); followed by property, pension fund and bank collapses.

In the globalised 'chain' there are many very weak links, and one of the biggest of the weak links is coming apart after 25 years of [government] failure to address any of the fundamentals.

In part this article reminds of Nassim Taleb's (the Black Swan) contention that the problem the bankers made (pre GFC) was that they understood risk or more accurately - what was true distribution of a risky asset. They assumed the normal ( bell ) curve when the true distribution was actually long tailed or unknown. Have they repeated the same mistake...

or [lose trust] in a given medium of exchange (e.g., US dollars, Japanese yen, gold, silver, etc.).

I think you can pretty much remove gold and silver from that list. If there was a loss of faith in fiat currency then gold and silver would make a moon shoot. They certainly wouldn't be regarded as commodities.

Note that one of the NORMAL buffers in the systemic risk matrix with regard to Financial institutions is the ability to lay off risk with insurance, one type being deposit insurance, which is in place in all developed western nations but glaringly non-existant in NZ due to the infinite wisdom of rbnz. Deposit insurance is a huge confidence booster for depositors so they don't cause a run on the banks in times of dire circumstances, which in turn stabilizes the whole financial system.
Incredible that the rbnz is so ignorant.

I have read all the comments and the overall tone is more than a little apocalyptic. The financial system is about to crash if you are all to be believed, but none of you say what you are doing to escape the consequences. Have you sold all your financial and property assets? Are you sitting on a pile of gold bars? If so, where does your income come from?
I am sure that there will be another market crash,but I have no idea when and As a resolutely dividend focused investor,I believe that I will survive as I I have survived every previous crash,bruised,but unbroken.