On Systemic Risk

Global Reset Series / by Ian Goldin /

In an increasingly interconnected world, the actions of the few can rapidly spiral into a global crisis. Policymakers must learn from recent events to control the risk latent in our interdependence.

Many of the greatest challenges of the 21st century are not new. These include the elimination of poverty and disease, the avoidance of conflict and nuclear proliferation, and the loss of biodiversity and natural resources. What is new is the nature of interdependence and complexity, as more integration among an increased number of people, combined with new technology, has led to greater fragility and the creation of a global risk society. The financial crisis is only the first part of the 21st century systemic crisis to manifest. It is vital that we learn from it in order to manage deeper and more damaging global challenges, such as climate change and global pandemics, and to avoid a destabilizing cycle of more acute financial crises.

Systemic risk is the underbelly of globalization and technical change. Intense integration of markets, trade, and finance has accompanied the latest tidal wave of globalization, facilitated by seismic policy shifts, like those associated with the fall of the Soviet Union, the formation of the European Union, and the opening of emerging economies. Between 1980 and 2005, global foreign-investment flows increased 18 times, and trade flows increased more than sevenfold, reflecting unprecedented integration.

Technological innovation has also spurred economic integration. The development of fiber optics, the internet, and mobile telephony, as well as exponential growth in computing power have virtually increased proximity. Physical proximity has also increased through technological innovation in transport and infrastructure, and the world’s urban population has increased dramatically, from 29 percent in 1950 to over 50 percent in 2009, as total population has doubled.

This global integration has been associated with unprecedented leaps in human-development indicators. However, risks arising from interdependency and complexity threaten to undermine and overwhelm the benefits of globalization. Systemic risks, which can lead to breakdowns in an entire system, are a growing hazard.

While the term “systemic risk” has historically referred mainly to collapses in finance, recent decades of globalization have created new and broader risks. There has been an exponential increase in the number of nodes and pathways through which materials, capital, information, and knowledge can be transmitted at lightning speeds and with global reach. These networks also have the potential to create and propagate risk. Interconnectedness, networks’ central property, can lead simultaneously to greater robustness and more fragility. Risk can decline as connectivity increases because as risk sharing increases, so does the number of nodes and links. This is true of financial systems, manufacturing services, intellectual property, and ecosystems. However, increased fragility is also a concern. Once a tipping point is triggered past its threshold, connectivity can amplify and spread risk instead of sharing it stably.

These new vulnerabilities challenge the very core of the benefits that globalization has produced, posing a fundamental challenge to global leaders and international institutions. Neither the present institutional structure nor currently planned reforms are fit for the challenge, as they fail to reflect the underlying threat of systemic risk.

The conditions that led to the financial crisis can serve as a lesson as we move forward in this era of interconnectedness and rapid technical change.

In finance, the rise of credit-derivatives networks caused connectivity in the global financial network to grow more dense than ever before, with nodes increasing 14-fold, and links between financial stocks becoming more frequent, increasing sixfold since 1985. Between 1998 and 2007, there was explosive growth in credit default swaps and collateralized debt obligations, as well as an increase in resale markets for capital. Whereas the trading of derivatives had been marginal in the three previous decades, by 2007 the market had expanded to $600 trillion, 16 times global equity market capitalization and 10 times global gross domestic product. These swaps contributed to network robustness by spreading risk through securitization, yet they rendered the system vulnerable to targeted attacks on its hub nodes, with the potential for risk amplification and contagion. It was ultimately the subprime crisis that triggered the financial crisis, but it was the underlying innovation, integration, and interdependency of the global financial network that created the system’s fragility.

The focus on innovation and spreading the risk got ahead of regulation. Traders’ incentives encourage them to create ingenious new financial instruments and, because of the constraints posed by regulators, to find new, innovative trading strategies to offset risks. Credit default swaps allowed firms to outsource their risks to counterparties and effectively decouple risk from responsibility. Individual actors had greater incentive to focus on network growth instead of network vulnerability, which has been shown to lead to systemic vulnerabilities in a variety of complex biological, technological, and financial networks. For individual traders, these were rational activities, even if the collective impact was powerfully destabilizing. The national and global regulators did not understand the complex underlying systemic risks festering under these new financial instruments, nor could they keep up with the pace of their innovation. The failure of regulators to appreciate the systemic nature of the risks was exacerbated and indeed informed by a new economic orthodoxy, as politicians and regulators drew comfort from the economists’ consensus regarding “the great moderation.” These failures marked a deeper failure to grasp the profound structural changes and new systemic vulnerabilities produced by increased integration and innovation. As a result, the system was overwhelmed by innovation that sidestepped underwhelming regulation. The growing gulf between oversight and market innovators rendered global finance fragile, a house of cards.

Systemic risk, as the world has learned the hard way, may arise as a result of the operation of market forces and is transmitted across geopolitical boundaries. As a consequence, it demands regulatory intervention as well as cooperation between countries. A new paradigm for dealing with systemic risk is needed.

Looming systemic risks include pandemics, which may spread more rapidly across a densely connected world, and bio-terrorism risks, which are likely to become increasingly systemic in the 21st century. The ability to produce biological and other weapons of mass destruction is becoming more widespread, especially among non-state actors, due to technological innovation (not least with the development of DNA synthesizers). Increases in population density, urbanization, and the growth of connectivity, both physically and virtually, means that dangerous recipes and panic can be instantaneously transmitted globally. And climate change, a silent tsunami that crept up on us, presents major systemic environmental, social, and economic risks to humanity.

Innovation, in part the cause of the financial crisis, should not be curtailed, but in a system rife with risk, more consideration must be given to the potential outcomes of new products. Climate change, like the financial crisis, is the inadvertent consequence of innovation. In this case, new inventions in the area of energy were the culprit, with well over a hundred years elapsing before the consequences of fossil fuel for the atmosphere and climate became known. Solving the climate crisis will require radical action and much more urgent applications of new energy forms and new governance models, together with innovative leaps, including perhaps in geo-engineering. It is vital that the implications are understood and that governance structures are updated to prevent a further escalation of systemic risk.

Faced with pandemics, security crises, threats of global terrorism and crime, climate change and many other looming threats, new approaches to global governance are required. This does not mean that nation-state governance will become less relevant, but rather that effective governance is required at both the national and global level. The stakes for getting global governance right have never been so high.

The omens, however, are not good. If past decades are any guide, new problems will be thrown at old and outdated institutions. Finance is the best equipped and most institutionally developed of the global governance regimes, yet the Bretton Woods, Central Banks and many other financial institutions failed to predict, prevent, or understand the endemic systemic risks in the system. Moreover, these institutions have yet to elicit the structural changes needed to proactively manage future systemic risks. Systemic risks ultimately require systemic responses. However, the pace of technological innovation may be expected to continue to outpace regulation, and even the best-equipped institutions will struggle to adapt to the rapidly evolving complexity of systemic risks.

We live in an increasingly interdependent global village, and we have benefited greatly from our interconnectedness. But we urgently need to learn from the financial crisis to ensure that we create collective management systems and resilience to weather the coming storms. Only by mitigating systemic risks can the unprecedented benefits of innovation and globalization be sustained in the 21st century.

Ian Goldin is director of the James Martin 21st Century School at Oxford University. This essay draws on an article in the journal Global Policy, coauthored with Tiffany Vogel.

Originally published December 16, 2010

Tags global reset globalization resilience risk systems

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