Growing Systemic Risk – Who Knew?

I’m writing today’s post while visiting historic Boston, Massachusetts to review a evolving technology platform for managing Enterprise Risk & Control Programs.  Since I’m in Boston, I thought it would be appropriate to share some insight from an Economist at the Federal Reserve Bank of Boston, Ralph C. Kimball.  Mr. Kimball published his article, “Failures in Risk Management”, in the New England Economic Review back in January 2000.  In his article, he describes in wonderful detail the forces of systemic risk that our economy is struggling with today – a full eight years after his writing.

As we are experiencing painfully today with the unraveling of financial institutions’ hedging strategies and use of derivatives such as credit default swaps, Mr. Kimball notes,

While an individual firm may mitigate its risks by purchasing insurance or hedging, these actions do not reduce systemic risk in the economy, but only transfer it elsewhere.”

This transfer of risk has been accelerated throughout the US and global economies by the fervent use of securitization and leverage.  Individual firms such as Washington Mutual, AIG and Lehman Brothers were acting in their own best interest while spreading the systemic risk contagion.  As Mr. Kimball rightly concludes,

“….the greater the amount of risk mitigation undertaken through hedging or the purchase of insurance, the more likely that unforeseen losses will migrate quickly from one market to another, or from one country to another. That is, while hedging acts to reduce independent risk, it can enhance systemic risk.”

What the economy is facing today is no surprise.  What is surprising is how long it took the Federal Reserve and others to address the mushrooming systemic risk infecting our economy.  Who knew?  Mr. Kimball knew.

What are your thoughts?  Share your comments below.

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Wheelhouse Advisors LLC is the publisher of The ERM Current™, an online publication and blog dedicated to providing the latest updates on current trends in Enterprise Risk Management & Control. Wheelhouse Advisors provides cost-effective Enterprise Risk Management & Control solutions to both large and mid-size corporations. To learn more about Wheelhouse Advisors, please visit our web site at www.WheelhouseAdvisors.com.

3 Responses to Growing Systemic Risk – Who Knew?

  1. C Neill says:

    Very insightful. I’d be interested in opening a discussion on the corporate hedging and the systemic risks created by these vehicles vs. the general practices of the banking industry to significantly relax lending practices and the sub-prime mortage explosion. Are these inter-related or cause and effect? Also, I’d be interested to see if Mr. Kimball has comments on the current situation and how firms can start planning for the next 3-5 years to recover and firm up overall approaches to risk.

  2. C Neill,

    The two are interrelated in that the hedge fund industry served as the fuel for the fire created by the sub-prime mortgage securitization fiasco. Firms were being rewarded by unregulated hedge funds purchasing mortgage backed securities and other collateralized debt obligations. The house of cards started to crumble when the monoline insurance firms began kicking back the agreements on these securities when the rating agencies finally started to downgrade these institutions. It is one long train wreck!

    WA

  3. Pingback: Risk Waits For No One « The ERM Current™

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