Investing requires people to make trade-offs between expected risk and expected return. Consequently, many investors have turned to sophisticated models to help develop their expectations. Ron Rimkus evaluates why models only capture risk relative to the market.

We hear a lot about systemic risk. What is it?

Systemic risk refers to the risks that emanate from the functioning of the financial system as a whole. Unfortunately, we have come to a point where the risk in the system is growing for a variety of reasons. As an industry we do a poor job of managing that risk.

How can we manage systemic risk?

It is easier to think about systemic risk in terms of factors that increase or reduce it. Some notable factors that increase systemic risk include outsized growth in debt and derivatives relative to assets; material changes in the ability or willingness to meet financial obligations; rising current-account imbalances across national economies; increasing density of networks of financial interdependence; increasing illiquidity of assets; and reductions in the freedom among people to transact. Conversely, factors that reduce systemic risk act in the opposite direction.

Why is systemic risk a problem for investors today?

Over the past several years we have witnessed an explosion in sovereign debt, credit creation, monetary policy, bubbles, derivatives and complexity of the system. This has been offset, in part, by productivity growth and modest inflation. Nevertheless, the growth in the negative factors is greater than the growth in the positive factors. So, on balance, systemic risk is increasing.

Conventional approaches to risk management use some form of regression analysis in their models. Is this a problem?

Models are simply measurement tools to help us understand the world. At the core, many of these investment risk models use regression analysis. Regression analysis defines the statistical relationship between a dependent variable and one or more independent variables. So we simply need to keep in mind that regressions describe co-movement of one variable relative to one or more other variables. Because it is relative, it cannot describe something absolute, such as the risk of the whole system.

We need to have clarity about what these simplifying tools can and cannot do.

What role does today’s foreign exchange system have in creating or mitigating systemic risk?

Since President Nixon moved the US away from the Bretton Woods gold exchange standard in 1973, leading countries have operated on a purely fiat money basis. Consequently, today’s monetary system enables countries to maintain current-account imbalances that would otherwise have corrected themselves. In so doing, individual countries build up sectors that are rendered uncompetitive when local currency exchange rates change.

What role do central banks play in creating or mitigating systemic risk?

When central banks set interest rates that are different from what free markets would determine on their own, it increases systemic risk. Likewise, when central banks act as lender of last resort, they effectively bail out banks that made poor choices and hence prevent the economy from allocating capital to only the best-run banks. Over time, this reduces the quality of banking in general and increases risk to the system.

Investors need to follow these systemic issues closely to identify whether specific actions are increasing or reducing systemic risk, as central banks are capable of both.

Which other sources of systemic risk have increased in recent years?

Hidden sources of leverage not only increase the leverage in the system, but also decrease trust in the system during periods of stress. One example of these hidden sources of leverage is the disappearance of the commercial paper market, hitherto an important source of funding, after the financial crisis of 2008. In its wake, investors have increased their appetite for liquidity, and accounting rules have made accounting for off-balance-sheet entities more difficult. Since the crisis, many smaller corporations have increased their reliance on bank loans and non-bank loans, and have not used commercial paper for their funding.

The next time the banking system turns sour on extending new credit, these corporations will be unable to roll over their debt, placing greater primacy on cash and liquidity at a time when the economy is probably heading into recession.

Of course, measuring systemic risk is a whole other problem. Some have suggested a simple scoring system that weighs the magnitude and direction of each of the systemic risk factors as one way for investors to overcome this challenge.

Ron Rimkus is a content director for economics and alternative investments at the CFA Institute

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