William Leiss: RiskBlog 1 March 2012
Once More, Understanding Systemic Financial Risk
Andrew Palmer’s recent essay on financial innovation in The Economist, “Playing with fire” [25.02.12: http://www.economist.com/node/21547999] has received a lot of attention. Read it, but also read the trenchant critique by Satyajit Das, one of the most perceptive observers on the subject. (Read his frequent blogs; his books, listed below, tend to be rather long-winded and egoistic, a compilation of scattered thoughts.)
The global financial crisis which began in 2008 is a slow-moving massive train wreck that may take an entire decade to bring under control. The catastrophic events of 2008 – still reverberating today, more than three years later, in the European sovereign debt crisis – have caused losses of many trillions of dollars. The scope of the losses is almost uncountable [http://bettermarkets.com/blogs/financial-reform-will-keep-wall-streets-hands-out-taxpayer-pockets, from “Better Markets,” a website I recommend]. This is why it is the best illustration of what I have called a “black hole of risk” in my book, The Doom Loop in the Financial Sector [www.blackholesofrisk.ca/].
Regulatory reform of the financial sector is designed to help us avoid a repeat of these events. But the struggle for regulatory reform is far from won, because of intensive lobbying by big banks and financial sector interests. The current battle is over the so-called “Volcker rule,” designed to reduce risks from investment banks trading on their own accounts: to understand this one, and others like it, follow “Baseline Scenario,” written by Simon Johnson and James Kwak [http://baselinescenario.com/]. If the bankers win this one, and others, they’ll do it again to the rest of us: Take obscene amounts of money for themselves during the good times, and saddle the taxpayers with the costs of bailouts when they bring on the bad times again.
Part of the reason for this extended train wreck is that at least one solution adopted by governments to respond to it is itself the cause of future problems. I refer to the central banks’ policy of mandating near-zero interests rates over long terms. It is already clear that this policy solution is devastating the financial health of insurance companies and pension plans, failing to rewards savers, and encouraging imprudent borrowing. Even the Bank of Canada, which joins other central banks in this flawed policy, acknowledges its downside risks, calling attention in its December 2011 review report to “a prolonged period of low interest rates, which may encourage imprudent risk-taking and/or erode the long-term soundness of some financial institutions” (preface, page 1), available at: [http://www.bankofcanada.ca/wp-content/uploads/2011/12/fsr_1211.pdf] Of course, it uses the typical wishy-washy bureaucratic language of “may” encourage or erode, which is irresponsible: The serious damage being done to the insurance industry and pension funds from the extremely low interest-rate policy of central banks has already been widely reported, and it poses a serious risk to the security of the future retirement plans of millions of Canadians.
In his recent blog, below, Satyajit Das explains that Palmer’s essay overlooks the most crucial truths about the nature of risk in recent financial innovations, among them: (1) a lack of transparency in the transactions; (2) a slow-growing “concentration” of risks that remains in the shadows until it’s too late to stop the collapse. This is what we now call “systemic risk” in the financial sector. A broad public understanding of systemic risk – which takes a bit of effort for citizens, I admit – is essential to build public support against the bankers for effective regulatory reform. The security of your retirement assets depends on your making this effort.