Is Systemic Risk at Risk?

No sooner has there been global acceptance of the magnitude of the role of systemic risk in the build up to the global financial crisis and in the nascent supervisory formula, than it appears that the very concept may now be at risk.

It is hardly an overstatement to assert that systemic risk has become the designer designation of the post-crisis international financial regulatory reform dialogue. It is clearly a central concept to the future stabilization of the global financial system and economy in its contribution to the crisis, the need for supervisory catch-up as to its occurrence and omnipresent character in financial markets as well as in the most effective integration of its role in financial system policies and in developing institutional and regulatory frameworks for a post-crisis era. However, this very acknowledgment of its key role has led to a quest to seek a formula for identifying systemic risk—set defined parameters around the concept to locate a unique formula in order to scientifically identify its presence in the financial system. This exercise is intrinsically flawed and detrimental to the promotion of financial stability.

For the purpose of identifying systemic risk, any exercise designed to create objective barometers for its identification could do this concept, including the work to introduce it into the supervisory fabric, and its evaluation a disservice. Despite the need for clarity and greater understanding as to how systemic risk could arise and the circumstances that could indicate the potential for financial crises to occur or develop, the reduction of the concept to a scientific or quasi-scientific formula and the further reliance on such benchmarks could be detrimental to its understanding and evaluation and in this way jeopardize the central relevance of the concept and place the key role of this concept in post-crisis supervision at risk. This tendency may further start a supervisory culture – one that the global financial system does not need – to conduct the assessment of systemic risk in a box ticking, objective fashion. Such an approach is flawed and is a retrograde step.

Macro-prudential supervision, the heart of which is systemic risk, calls for greater discretion instead of a static, rules based approach to assessing stability. As a reminder, traditional micro-prudential supervision has clearly left the financial system vulnerable on a number of bases – (i) it has focused too strongly on institutional safety and soundness and the assumption that this would be a reliable indicator of the overall resilience and stability of the broader financial system; (ii) it has not reflected the links between the financial sector and the broader economy; (iii) it has not been reflective of risks on a level that transcends the traditional labeling of financial institutions; (iv) it has relied largely on the application of such objective criteria and (vii) it necessarily cannot keep step with the pace of non-static, constantly evolving financial markets.

Having made significant strides in the acknowledgment and introduction of systemic risk in legislation, regulation and policy, the tendency to develop and rely on objective criteria for the identification and further assessment of systemic risk and its consequences could significantly weaken advances in this area. Seeking to reduce it to a magic formula or to design objective barometers for its identification is not prudent. This could not only lead to distorted results and threats to the broader system, but is also an over-simplification of the concept and the institutional measures such as the Financial Stability Oversight Council recently introduced to address it.

While, over-reliance on size or any other factor should be resisted as an indicator of systemic importance equally it would be erroneous and therefore miss the point to assert that the key to systemic risk lies in any particular nexus or may be inferred from the correlation between a firm’s risk and a sector.

Given these trends it appears that at the moment the treatment and understanding of systemic risk could very well be at risk as a result of the the over-simplification and formulaic approach that has necessitated a different form of supervision from that which has dominated prior to the global crisis. The quest for defining its parameters, context and for putting a workable framework to its analysis could hamper the subjective and real-life analysis that would better serve this arena. The key to systemic risk does not lie in any magic formula. Instead, its clarification results from a greater understanding of the linkages of finance, supervision and stability.

Instead, the concept of systemic risk calls for a full understanding of the financial markets and a flexible assessment of the circumstances in which systemic risk could occur – rather than an attempt to distill this concept into a formula to identify its occurrence.

The real key to understanding systemic risk is the appreciation that the greatest indication of system-wide vulnerabilities arises from an understanding of the circumstances in which systemic risk could arise and a judgment on a case-by-case basis of the translation of such risks into economic and broader disruptions. It is a question of experience and understanding of risk, financial markets and supervision in practical terms, not one that relies on the application of pre-set criteria. Therefore while it may appear comforting in new supervisory territory to propose a magic link that constitutes or triggers systemic risk, this could be anathema to its true evaluation.