Reflexivity of Risk
George Soros says that financial markets are reflexive. He means that the participants in the system influence the system. Market prices reflect not just fundamentals, but investors expectations.
The same thing is true of risk systems. This can be illustrated by a point that is frequently made by John Adams. Seat belts are widely thought to be good safety devices. However, Adams points out that aggregate statistics of traffic fatalities do not indicate any improvement whatsoever in safety. He suggests that because of the real added safety from the seat belts, people drive more recklessly, counteracting the added safety with added risky behavior.
That is one of the problems that firms who adopted and were very strong believers in their sophisticated ERM systems. Some of those firms used their ERM systems to enable them to take more and more risk. In effect, they were using the ERM system to tell them where the edge of the cliff was and they then proceeded to drive along the extreme edge at a very fast speed.
What they did not realize was that the cliff was undercut in some places – it was not such a steady place to put all of your weight.
Stated more directly, the risk system caused a feeling of safety that encouraged more risk taking.
What was lost was the understanding of uncertainty. Those firms were perfectly safe from risks that had happened before and perhaps from risks that were anticipated by the markets. The highly sophisticated systems were pretty accurate at measuring those risks. However, they were totally unprepared for the risks that were new. Mark Twain once said that history does not repeat itself, but it rhymes. Risk is the same only worse.
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