Since 2008, the phrase “systemic risk” has been on the lips of politicians, policy makers, academics and journalists but scarcely, if ever, did any of them consult anywhere as to what the definition of systemic risk is and what is its measure.
Of course, none could because there is no acceptable definition of it nor is there a widely accepted measure of systemic risk.
The fact that the infamous Dodd-Frank finance legislation rests on a nonexistent definition of the very phenomena it attempts to legislate is a rather oxymoronic predicament, and not just that it is over 2,319 pages long.
“The systemic risk research agenda aims to provide guidance about the consequences of alternative policies and to help anticipate potential breakdowns in financial markets. The formal definition of systemic risk is much less clear than its counterpart systematic risk,” writes Lars Peter Hansen from the University of Chicago in his just released paper Challenges in Identifying and Measuring Systemic Risk.
Worse yet, there is not even a widely accepted measurement of the systemic risk although various schemes for measuring it have mushroomed.
“As systemic risk remains a poorly understood concept, there is no ‘off the shelf’ model that we can use to measure it. Any stab at building such models, at least in the near future, is likely to yield, at best, a coarse approximation,” writes Hansen.
According to the Office of Financial Research at the US Department of the Treasury, there are 31 ways to measure systemic risk – an “embarrassment of riches” that perhaps just adds to the confusion.
Hansen says that systemic risk cannot be measured but instead we should focus on systemic uncertainty.
“Even as we add modeling clarity, in my view we need to abandon the presumption that we can measure fully systemic risk and go after the conceptually more difficult notion of quantifying systemic uncertainty,” says Hansen.
Before even spitting out a probability number for an outcome of an event, risk understands, first, that an event could possibly exist in the future that could adversely alter financial circumstance of at least one financial party. Uncertainty, however, refers to a situation where something will happen but market participants have no clue what that event will be.
So, how does one measure events that one has no clue what they could be?
Hansen leaves that for the econometricians but instead he is confident that the “concerns about systemic uncertainty would still seem to be a potential contributor to the implementation of even seemingly simple rules for financial regulation.”
… like, few pages less than Dodd-Frank’s 2,319?
On the Web:
- Challenges in Identifying and Measuring Systemic Risk by Lars Peter Hansen
- A Survey of Systemic Risk Analytics by Dimitrios Bisias, Mark Flood, Andrew W. Lo, Stavros Valavanis, Office of Financial Research.