Waking up to Risk Redux: Is Nassim Taleb the Regulatory Rock Star?

Systemic risk. "Fat tails." Six-sigma events. I've written about this stuff quite a bit during my time as a blogger. I've made the point that the real risk regulators should be focused on is systemic risk, not fund-specific risk. All the hoopla around hedge fund registration is, from my perspecive, a red herring. The goal of regulation should be to protect the markets, not to protect a group of institutional investors who conduct poor due diligence by hampering the flexibility and money-making ability of all hedge funds. And I've seen the leading regulatory regimes across the globe evolve to the point where they, too, are focusing on systemic risk as opposed to single-fund risk. And this is a very happy development indeed.

This point was made most recently during Anthony Ryan's speech at the Managed Funds Association conference in Chicago. Mr. Ryan is currently Treasury Assistant Secretary for Financial Markets. It is also interesting to note that I touched on this very same topic in my post on New York City last night. I am including some key points from Mr. Ryan's address; please let me apologize in advance for its length but his talk was very, very good.

...I would like to focus on the issue of systemic risk. We will never eliminate the potential for systemic risk, but we can seek to reduce the probability of it occurring and its impact. My purpose today is to sensitize all of us as to how systemic risk operates and urge all stakeholders in our capital markets to take the necessary steps to implement policies, procedures and efforts to mitigate it.

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Systemic risk can be defined as the potential that a single event, such as a financial institution's loss or failure, may trigger broad dislocation or a series of defaults that impact the financial system so significantly that the real economy is adversely affected.

Some may posit that the increasing sophistication of risk management systems coupled with other developments and efforts has placed systemic risk on the endangered species list. For supportive proof they point to the lack of extensive ripple effects upon the financial markets following some relatively recent shocks.

I'd like to elaborate why, given market conditions, I believe that subscribing to this thesis is both potentially misleading and imprudent. Let's begin with answering the question: how could a systemic risk event manifest itself? Meteorologists describe atmospheric conditions conducive to producing a perfect storm. What are the atmospherics for a perfect financial storm? While there would be several, let me name a few: easy credit and leverage, highly correlated strategies, connected and concentrated lenders, inadequate information, and underdeveloped financial market infrastructure.

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Could our capital markets practices' better play have influenced the distribution of risk events such that the tails of the distribution have shortened? It is true that the dispersion of risk is greater. The presence of so many derivatives strategies and instruments do help to hedge risk, and markets have adjusted to "tremors." At the same time, we can also observe that the capital markets, with a few periodic exceptions, are not pricing risk and future volatility anywhere near close to long-term averages.

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So, the long tails of some distributions may also be a lot fatter than people frequently assume. Besides baseball salaries, there are many other data series where the distributions are anything but normally distributed. Look at "book sales per author…populations of cities…numbers of speakers per language, damage caused by earthquakes, deaths in war, deaths from terrorist incidents…or the sizes of companies."

Could the same be true of capital markets, commodity prices, inflation rates, and economic data? If so, what are the implications? What if such events occur with much more frequency than people recognize, and what are the consequences if we do a particularly poor job in preparing for them?

One student of such distributions is Nassim Taleb. He defines an occurrence such as a systemic risk event as follows: "First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable."

If we can not predict a systemic market event in advance, and we seek to reduce the impact of such an event, we must prepare.

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So the tails may be longer than people imagine, and the tails could also easily be fatter. We must therefore be humble enough to realize that a systemic event in the financial markets cannot be discounted and its impact will be significant.  Preparedness is therefore key and all stakeholders in the capital markets must contribute to the effort.

So there you have it. I believe Mr. Ryan's characterization of the challenges facing both regulators and market participants alike are spot on. And he and his colleagues are now internalizing the risks long understood by Mr. Taleb, risk managers and traders at every major financial institution: the risk of long-tail ruin is real and it occurs far more frequently than normally-distributed models would predict. Tails in the financial markets are fat - very fat - and the best we can do is to make sure the system can withstand significant and unpredicted shocks, because they will happen. And we have history as our witness.

Comments

[serpah]

Fascinating stuff. I'm not an investment expert, but I am an investor and seeing the fallout of long-tail events is scary. How do you prepare for something like that?

[Shrek]

The Fed is kidding themselves. How do they counter systemic risk when the dominant players are FCB's?