Photograph of an adult hand knocking over a string of dominoes.

It's Coming... But When?

Living With Systemic Risk

In the climactic scene from the cult movie classic Big Trouble in Little China, the movie's hero, Jack Burton (played by Kurt Russell) knocks over the first in a long line of Buddha-esque porcelain statues in cursed Emperor David Lo Pan's throne room. Each statue tumbles into the one beside it, one after another, leaving the chamber littered with porcelain shards and Lo Pan's empire in a state of collapse. 

It's an illustration of "systemic risk" – an antiseptic regulatory term that refers to hidden threats that could topple the global financial system because of what's known as the cascading effect: the finance equivalent of one statue falling into another. Recently, concerns over "contagion" from Chinese conglomerate Evergrande's solvency have rattled global markets and brought the specter of systemic risk to the forefront yet again. 

With financial assets at historically high valuations and excesses popping up across the board, there is growing concern about where the cause of the next financial crisis might be hiding. 

Fingers have been pointed at:

  • Retail "meme" trading in stocks like GameStop. 
  • A default by the U.S. Treasury if the debt ceiling isn't raised
  • Negative interest rates.
  • Bitcoin volatility.
  • Swap contracts. 
  • The new "wild west" of decentralized finance, or DeFi. 
  • Money market funds (which precipitated the last crisis). 
  • Climate change exposure in the lending portfolios of banks and in muni bonds. 
  • Exchange-traded funds. 
  • The surge in private credit. 
  • Growth in margin lending and securities-based loans. 
  • Even index funds. 

What makes any and all of these a potential catalyst is, ironically, the complexity and interconnectedness of the financial system that undergirds financial capitalism, the dominant socioeconomic system in the world. One of the wonders of the modern era, our global financial system is actually more subject to collapse than it was, say, a century ago.

On one hand, the regulatory infrastructure is far more advanced, battle-tested and sophisticated than it was after our last two major financial crises, the Great Depression and the Great Financial Crisis a decade ago. 

But with complexity comes increased fragility, a point that Nassim Nicolas Taleb makes in his books The Black Swan and Antifragile. Simple systems are resilient. Complex systems are fragile. In today's interconnected global financial system, a shock anywhere in the financial system goes deeper, travels faster and affects other players around the world far more dramatically than ever before.

Any one individual or institutional statue toppling over isn't in and of itself a problem. A recent example of this of Archegos Capital, the family office run by Bill Hwang, which imploded due to leveraged long equity positions embedded in total return swaps. 

Multiple financial institutions were dented by their exposure to Archegos losses, including Credit Suisse ($5.5 billion), Nomura ($2.9 billion), Morgan Stanley (nearly $1 billion) and UBS ($774 million). But none so seriously they risked falling over. 

Archegos exposed one of the fundamental contributors to systemic risk – lack of transparency. Not one of Hwang's counterparties fully understood the size and concentration of the stock exposure he accumulated because disclosure rules for total return swaps had not yet become effective. 

In the wake of the last financial crisis, Congress created a new regulatory oversight body, the Financial Stability Oversight Council (FSOC). Chaired by the U.S. Secretary of the Treasury, it includes the chair of the Federal Reserve, the Comptroller of the Currency (OCC), the Consumer Financial Protection Bureau (CFPB), SEC, FDIC, Commodity Futures Trading Commission, among others. Its job is to scan the landscape for vulnerabilities in both the regulated and unregulated (or shadow banking) sectors of the financial system and act to address them before any meltdowns occur. 

The FSOC reported to President Biden last spring that "the financial system is in strong condition... financial risks are being mitigated by robust capital and liquidity levels in the banking system and healthy household balance sheets."

But there are several challenges with the FSOC's early warning system.

First, as Financial Times columnist Gillian Tett wrote recently, it is devilishly "hard to tell where pockets of excessive leverage lie." Second, even when risks are identified, opinions are often split on whether they are systemic in nature. On the one hand, if all the bitcoins outstanding lost all their value "its holders would lose hundreds of billions of dollars but that... fallout would be manageable," the Economist wrote recently. On the other, Tether stablecoins, another digital currency worth approximately $62 billion and only partially backed by commercial paper, are just about the size of the Reserve money market fund whose Lehman Brothers commercial holdings caused it to "break the buck" and precipitated the last financial crisis. 

Finally, there is always a tradeoff between protecting against systemic risk and permitting the free flow of capital necessary to fuel economic activity. One analogy used by former Fed Chairman Alan Greenspan has stayed with me over the years. He likened financial regulation to building levees in coastal cities. The question is how high to build the dikes. High enough to protect against a 50-year flood? A 100-year flood? The higher the levee, the better the protection... but the more it costs. The same is true for financial regulation – only its cost comes in the form of reduced economic activity. 

Improving disclosure is a relatively low-cost preventative measure. As former SEC Chairman Arthur Levitt declared, "The more you know, the less risk you take." But only up to a point. Taleb warns that "gains in our ability to model (and predict) the world may be dwarfed by the increases in its complexity – implying a greater and greater role for the unpredicted."

Put another way by Taleb: "Globalization has created this interlocking fragility, while... giving the appearance of stability." We must continue to balance regulation and risk to maintain the resilience and vitality of the global financial system. 

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