Firms Can Treat Systemic Risk Same as Emerging

As one looks back at the recent history of the financial crisis, it can now be clearly seen that a large number of financial firms and a few regulators did identify the looming problems and took reasonable steps to avoid excessive losses. Almost all of the attention has been on the firms and regulators who missed the crisis until it was much too late.

Now, everyone is talking about how to avoid the next crisis and the focus seems to be on the regulators and the largest firms – in short, those who got it wrong just a few years ago.

“The unknown losses can potentially bring the system to a halt at a much lower amount of loss than known losses.”

But we should also be focusing on what everyone else could be doing to prevent their firms from experiencing excessive losses in future crises.

Planning to have no future crises is not a realistic way to proceed [see my earlier article: IERM, Risk governance, 16 September 2009, “Understanding the four seasons of risk management“). The broad idea of Basel II and Solvency II is sound. Firms would be forced to identify their risk exposures and compare that to their capacity to bear risk. That information would be available to five groups under the three pillars: management, boards, regulators, investors and counterparties. It is assumed that one or more of the five groups would notice upticks in risk and prevent the firms from taking on more risk than their capacity to bear that risk.

There have been many problems with the execution of those principles and Solvency II is just starting the discussion of exactly what information will be made available for investors and counterparties. But the broad idea of disclosure to all those groups is sound. The disclosure of potential systemic risks is absolutely necessary for firms to use as a basis for developing their own programmes for avoiding excessive losses in these situations.

Systemic risks

The way that the term “systemic risk” is used and misused, it seems clear that most people understand that systemic risk was a problem that led to the crisis, but beyond that there is little consensus, other than a conviction that we want much less of that in the future. The IMF provides a definition:

“the risk of disruption to the flow of financial services that is (i) caused by an impairment of all or parts of the financial system; and (ii) has the potential to have serious negative consequences for the real economy.”

Had the quote ended after 10 words, that would have been sufficient.

For the system to be disrupted, two things need to be true:

  1. there needs to be an exposure that everyone believes or suspects will turn into a loss of an amount that exceeds the capacity to bear losses of a large number of participants in the system and
  2. there needs to be either a high degree of interdependency in the system or else widespread exposure to the loss-making large exposure. The system may seize up because the losses are known and the institutions are known to be insolvent or more commonly, because the losses are unknown.

For the rest of this discussion go to InsuranceERM.com

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Explore posts in the same categories: Black Swan, Emerging Risks, Systemic Risk

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