May 24, 2004

The Myth of Systemic Risk

At a St. Louis Banking Conference, Professor George Kaufman presented a thesis of his that "systemic risk" is a myth [1]. It goes like this: Systemic Risk is that risk of contagion, whereby a failure causes a domino-like collapse of large segments of the system. Professor Kaufman makes the claim that an institution that is financially sick should fail, and that isn't a case of systemic risk. Those that are financially healthy should not fail, and if they do, it could be systemic risk.

He then goes on to challenge his listeners to find an example of an economically solvent bank that was brought down by a run, anywhere in the world. So far, no joy - he's not been presented with any such cases, although like myself and the MITM, he holds out hope.

Which leaves us rethinking the S&L scandal, the Asian crisis, and sundry other squillion dollar collapses (in another paper, he presents just how devastating these collapses are [2]). If all those countries in Asia back in the late 90s were insolvent, or at least financially unsound, then he asserts that they shouldn't have been propped up. When the Asian dominos wobbled and fell, that was an example of proper bankrupcy procedures, albeit at a national level, rather than systemic risk.

What are the consequences of this? One of the underlying justifications for central banking was that they could protect the system from systemic risk. That crutch is now removed from the Central Banks and their role as centralised regulators. Other crutches such as monopoly issuance of money, and the myth of "banking is special" have been under stress for many a year.

To some extent this has already been predicted; it's been clear for some time that the 20th century was the Golden Age of Central Banks and now everyone is posturing for, or at least fearing, a gradual waning of their influence and place in financial society.

On a more personal note, when we built Ricardo and our real time gross settlement system of trading, we used to say that we'd eliminated sources of systemic risk. Maybe we should back off from that and just claim the elimination of other classes of risk, and a reliance on the supreme savings of cheap RTGS trades (one or two orders of magnitude, but who's counting?). Or maybe not; is there a contradiction in claiming the elimination of something that doesn't exist?

[1] Professor George Kaufman, "The Myth of Systemic Risk," remarks presented at the St Louis Banking Conference,
[2] Professor George Kaufman, "Banking and currency crises and systemic risk: Lessons from recent events," Federal Reserve Bank of Chicago, volatility/contagion/documents/3qep2.pdf

Posted by iang at May 24, 2004 04:22 PM | TrackBack

If we were talking about the weather and we were to speak of being responsible for weather stability, everyone would consider us lunatics. No one controls the weather. You can only do so much to try and predict and for the rest you must make sure you can respond quickly to changes in the weather.

Still, if you wear a suit and tie and throw in some abstract terms and inappropriate examples such as the domino-effect, bank runs, etc, you can cheat the public into believing that there are good reasons to spend tax money on an institution that is dealing with financial stability and systemic risk.

Now I am not against these institutions, but they could be a little more realistic and humble in their approach.

Posted by: Simon Lelieveldt at May 27, 2004 08:54 AM

Maybe that's why the weather man wears a suit and tie.

I don't know if humility works. I seriously wonder whether truth, honesty, integrity to purpose, and openness has a place in Central Banking. It seems that if everyone knows the innermost thoughts of the central bankers, that just gives them an opportunity to take the CBs down in a play. They are, after all, by definition, smarter than the central bankers.

It seems the only defence against an aggressive speculative sector (an essential element of the market) is to shroud the CB affairs in mystery and the occult. So nobody can really be sure what's going on.

The problem occurs, it seems, when the central banker believes in his own myth.

Posted by: Iang at June 7, 2004 07:07 AM

First of all what does George Kaufman mean by the phrase "economically solvent"? In this day and age with sooooooooo many moral hazards *imposed* on banks, I haven't a clue.

An "economically solvent bank" may at this point in history be an urban myth.

Probably for most at the St. Louis Banking Conference it wouldn't be too good for their careers if they came up with an example assuming he defined his concept.

If the Asian dominos were not a big enough system for the word systemic to be used, wait till the $300 trillion or so notional value of derivatives in the world blows up. All fraud comes to an end. These over the counter derivatives are probably the biggest criminal activity in the history of man.

Posted by: Bob at October 14, 2004 07:22 AM