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Saturday, June 26, 2010

Systemic risk a puzzle or mystery?

THINK ASIAN By ANDREW SHENG

MALCOLM Gladwell deserves his reputation as one of the most brilliant and popular writers today. His books – The Tipping Point: How Little Things Make a Big Difference, Blink: The Power of Thinking Without Thinking, Outliers: The Story of Success – all became No. 1 bestsellers.

I just read his latest book, What the Dog Saw, actually a compilation of his New Yorker magazine articles. He is brilliant because he looks from an angle that most of us miss. He did not think what you and I think when talking about a dog; he looked at what the dog thinks.

In the chapter titled Enron: Open Secrets, Gladwell posed the right question: Was the failure of Enron a puzzle or mystery?

A puzzle is something that can be solved with extra information. A mystery is a question that may not have simple answers, requiring judgment and the assessment of uncertainty. “The hard part is not that we have too little information, but that we have too much,” he wrote.

He concluded that Enron was not a puzzle, but a mystery, since Enron disclosed most of the information according to the (then) accounting rules. Exactly like the current crisis, Enron had the best professionals working for the company, but no one stopped the company producing misleading accounts until it was too late.

In this age of high transparency, crises happen openly. Why? In Enron, Gladwell posed the issue: “It’s almost as if they were saying, ‘We’re doing some really sleazy stuff in footnote 42, and if you want to know more about it, ask us.’ And that’s the thing. Nobody did.”

Gladwell asked, “Had we taken the lessons of Enron more seriously, would we have had the financial crisis of 2008?”

Right question. But why did nobody, especially policymakers and regulators, ask the right questions? Is the current global crisis a puzzle or mystery?

There is general acceptance by financial regulators (in hindsight) that what we all missed during the current crisis is systemic risk, which is defined in Wikipedia as “the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system”.

It can also be defined as the serious destabilisation of the financial system, caused or exacerbated by failures in parts of the system that spreads through the financial system and the real sector.

Systemic risks are risks passed through common interlinkages and interdependencies in a system or market, through contagion that leads to a system-wide cascading failure.

Most regulators would agree that systemic risks are not usually measured by micro-prudential regulators, who focus mostly on institutions or processes. It is now fashionable to talk about “macro-prudential regulation”.

The current reforms in the United States and European Union vigorously debate how to measure, monitor and control systemic risks. These range from creating an independent “financial stability council” specifically to comment on systemic risks, the use of a tax to reduce systemic risks, and more regulations and reporting requirements.

Everyone seems to agree that we need to control the “too big to fail” banks and the “too interconnected to fail” smaller institutions, such as hedge funds. There is general agreement that all scope of regulation should cover all institutions that generate systemic risks.

The trouble with controlling systemic risks is that they are not easily identified. We know that systemic risks are generated by behaviour, that they are inherent in eco-systems and that they have macro as well as micro origins. But we do not know the trigger when these risks begin to cause real problems.

We now face the Gladwell question: Is systemic risk a puzzle or mystery?

If it is a puzzle, then if we find the right information, we can have the right solution. But if it is a mystery, then we may have to think about the problem completely differently.

Gladwell thinks that puzzles are “transmitter-dependent”, depending on what we are told. Mysteries are “receiver-dependent”; they depend on the skills of the listener. If the public does not understand the risks, then the risks will happen.

Systemic risks are related to the system as a whole and also the behaviour within the system and also the commonalities within the system that create the contagion.

Understanding this means that we need to understand not just the dynamics of the financial system itself (what is endogenous to the financial sector), but also the complex exogenous inter-relationships within the financial sector and the real sector.

It means that we have to understand the reflexive actions between parts of the real and financial sectors.

This is an epistemological question, the science of the limits of knowledge. Suppose we have a super computer that is able to digest every bit of information, can we accurately estimate systemic risks? What if systemic risk stems from the fact that the externality of what we do (everyone in the financial system) generate enough spillover effects that create a massive disaster?

In other words, are we dealing with the unknown unknown? These are sometimes called acts of God.
Perhaps the recent preoccupation with risk management models and information systems that assume that we can calculate all the risks is wrong.

We now know that the current generation of risk models cannot cope with Black Swan or extreme event risks.

Risks can be reduced in four main ways: avoidance, diversification, hedging and insurance by transferring risks. The current generation of regulators thinks that diversification, hedging and insurance is a science that can be measured. This crisis proved that they are wrong. There is much about systemic risks that we do not understand.

Hence, it is better to have ample capital and simple “avoidance behaviour” or prudence in whatever we do. Regulators have the unpleasant task of saying no when no one understands what the risks are.

Risk prevention or avoidance is still an art, not a science. We need to be humble that we do not yet fully understand how our systems work or fail, hence the need to be “balanced” or finding the golden mean. When everyone thinks something is right, it could very well be wrong.

·Tan Sri Andrew Sheng is adjunct professor at Universiti Malaya, Kuala Lumpur, and Tsinghua University, Beijing. He has served in key positions at Bank Negara, the Hong Kong Monetary Authority and the Hong Kong Securities and Futures Commission, and is currently a member of Malaysia’s National Economic Advisory Council.

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