The Do We Understand Systemic Risk? panelists presented their views on systemic risks within the global financial system. Arguments included that a too tightly coupled system with too much focus on efficiency has led to sudden eruptions and increasing risks; a need exists to examine the spillover effects of a country’s policies and to have multilateral surveillance that can influence those policies; and the need for diversity to ensure systemic resilience and how to achieve that.
Do We Understand Systemic Risk?
Chair: John Helliwell, co-director and Arthur J.E. Child Foundation Fellow, Canadian Institute for Advanced Research
Thomas Homer-Dixon, CIGI chair of global systems, Balsillie School of International Affairs
Thomas A. Bernes, former director, Independent Evaluation Office (IEO) of the IMF
Avinash Persaud, founder and chairman, Intelligence Capital Ltd.
We are dealing with risk and profoundly with uncertainty, Thomas Homer-Dixon said at the beginning of his presentation. He cited Frank Knight, “the unknown unknowns” and asked whether the crisis is an epistemological or ontological uncertainty. Dr. Homer-Dixon said it is an ontological or intractable uncertainty with various kinds of financial innovations.
Dr. Homer-Dixon referred to systemic uncertainty and severe sudden eruptions that create increasing risk. Exogenous shocks to the world economy are exceedingly rare; endogenous shocks arise from an opaque and restless financial system. Endogenous shocks are increasingly frequent and severe.
The causes, he said, are a too tightly coupled system and too much focus on efficiency. There is also a loss of slack and diversity. The tightly coupled global economy creates enormous capacity for contagion. Moreover, excessive global connectivity multiplies pathways for the propagation of local shocks, resulting in a global impact. Dr. Homer-Dixon spoke of how the concentration of power in a few hands in some industries — jetliners, jet engines, tires and glass bottles — dominate resource use to the point of squeezing out smaller players. This in turn results in a loss of diversity and options. The downside of the excessive emphasis on efficiency, he said, is loss of slack and susceptibility to cascading failures.
According to Dr. Homer-Dixon, the emphasis should be shifted to developing resilience at the company level, so that the economy can withstand shock. He talked about the economy not being linear, but rather being an inverted “U.” with an increase followed by a plateau and then a decline. He concluded by saying that being more connected and more efficient is not necessarily better and that diverse experimentation is needed.
Thomas A. Bernes
We can identify risks when we see them, said Thomas A. Bernes, but we need to get better at identifying what combination of risks cause systemic shocks. The IMF is responsible and therefore accountable for the identification of risks, but a need exists for it to address spillover effects of country policies much more effectively. Mr. Bernes referred to two surveillance products within the IMF, the World Economic Outlook (WEO) and the Global Financial Stability Report (GFSR), which respectively have a macroeconomic and a financial focus. The WEO and GFSR look at how developments affect the global economy and, at least in theory, how financial developments can affect the real economy and economic performance. However, limited progress has been made on integrating these analyses, for instance in giving to little attention to the impact of deregulation and innovation on the macro-economy. Until recently, the GFSR focused more on emerging market consumer debt as a potential source of problems while largely ignoring, household credit growth in mature economies.
According to Mr. Bernes, global imbalances are an important contributing factor. Attention has shifted to reinvigorating surveillance through a shared knowledge base and collaboration. The IMF is “back in business” he said, with one last chance to show it can play a valuable role. The Fund needs better analysis and focus and surveillance of countries that can make the most waves in the global economic system. The previous early-warning system didn’t work.
To make a difference, multilateral surveillance requires the ability to influence individual country policies. Moreover, Mr. Bernes asserted that the chief weapon is persuasion (in the form of private advice and peer pressure), not sanctions. Peer review at the Fund board doesn’t mean much. Policies should be designed base on how other countries will act. He concluded by asking: what will be different this time?
The enormous economic and social impacts of the current crisis make it a little impolite to say so, but crises are huge learning opportunities and this crisis offers up much to be learned about the policy process and the political economy of crisis, said Avinash Persaud. When the crisis erupted regulators were admirably quick to identify the causes of the crisis – an exclusive focus on micro-prudential regulation and inadequate focus on the macro-prudential. Crises are macro. Crises are not caused by random acts of mischief – crashes always follow booms. But blaming the “pro-cyclicality of the system” does not capture the imagination of the voters who want to see retribution and public executions. So, politicians quickly brushed aside the macro and focused on the bad apple theory of financial crises: they are caused by bad bankers selling bad products out of bad jurisdictions. The problem with this theory is that it lends itself to even more micro-prudential regulation.
Systemic resilience requires diversity. It requires there to be buyers when there are sellers, because they have different views about value and risks and have different strategies and different capacities. The scale of the selling was one problem, but it was the fact that there were no buyers that turned a problem in one small part of a small section of the financial sector into a major dislocation. Sources of homogeneity are (1) the credit cycle, (2) a small number of large and inter-connected institutions and (3) the mistaken belief in a level playing field and using common standards and rules to achieve it. A key natural source of heterogeneity is funding and liabilities and regulation needs to view these differences as providing risk capacity not forcing these differences away through the adoption of common prudential controls such as use of public rating agencies, or the adoption of single valuations such as mark-to-market value accounting, or the adoption of single risk management systems such as those based on Value at Risk. There is an uncomfortable trade-off between micro-prudential regulation and macro-prudential regulation and politics is encouraging regulators to focus on the former at the expense of the latter, condemning us to repeat the cycle.