The Rise of Systemic Financial Risk

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TR: So one person, in this case Mr. Kerviel, can move the entire global financial system.

AL: It's a larger-scale version of what happened in August of 2007--in particular, August 7, 8, and 9. A large number of quantitative equity hedge funds lost money on those dates simultaneously, yet there is no market event that you can point to that can explain why these funds lost money at the same time. But looking at circumstantial evidence, we [at MIT] pieced together a story that one large quantitative equity fund decided to unwind its portfolio, for reasons we don't know for sure, but which we conjecture to be related to credit problems from the subprime mortgage market. Because the conjectured liquidation involved a big fund that needed to be liquidated quickly, this implies that the impact of the liquidation on other similarly positioned quantitative equity funds would be negative--and large. You get a snowball effect. Everybody is heading for the exit door at the same time, and you get a crash. But in August 2007, it was not a crash of the market as a whole, but of portfolios that are similarly structured to the fund that started the snowball.

TR: So how can we mitigate these kinds of wider risks?

AL: Probably the best way to reduce the impact of systemic shocks is to provide investors with some transparency as to their likelihood and severity, and let the investors decide how much risk to bear. This is probably best accomplished by creating a government organization like the National Transportation Safety Board, charged with the mandate of analyzing every financial blowup or crisis and producing publicly available reports that describe the nature of the crisis, the circumstances leading up to it, and proposed methods for avoiding such incidents in the future. In the same way that the NTSB has improved the safety of air travel by sifting through the wreckage of every airplane crash and publishing a detailed study of its findings and recommendations, a Capital Markets Safety Board would give investors more insight into the risks of any given investment. Over time, the aggregate information produced by the CMSB would shed additional light on the nature of systemic risks for the entire global financial system.