The Doom Loop in the Financial Sector: And Other Black Holes of Risk

Chapter 1 Black Holes of Risk

1 The science of risk management sometimes creates new risks, even as it brings old risks under control. Our faith in risk management encourages us to take risks we would not otherwise take. On most counts, that is beneficial, but we must be wary of adding to the amount of risk in the system.—Peter L. Bernstein (1996, 335) Two important ideas are contained in the passage quoted above. First, in the process of seeking to control the risks that we recognize and understand—risks that are well described using formal techniques developed in the field of risk management—we should be aware of the possibility that, in this very process, we may be creating new risks that we are utterly unaware of or misunderstand. Second, there is the possibility that, in substituting obscure risks for better-known risks through our carelessness in risk management , we may actually increase, rather than diminish, the adversities that can result from the sum of all the risks we face. Two main theses related to these ideas are explored in this chapter and in Chapter 3, and illustrated by the case study of risk in the banking and financial industries in Chapter 2. One thesis is that some people have begun to use very limited capacities for managing risks sensibly to justify making bigger and bigger bets on the outcomes of economic policies and technological innovations. The other thesis is that, by throwing caution and precaution to the winds in making such bets, such people are exposing themselves, and Chapter 1 Black Holes of Risk 2 | The Doom Loop in the Financial Sector others, to potentially catastrophic downside risks, including a type of collapse in social systems so severe in its consequences that recovery from it—that is, restoration of the status quo ante—is either impossible or, if possible, only over a very long time frame. As globalization proceeds apace, drawing all nations and regions on the planet into its orbit, the scope of the downside for some of the risks initiated in the developed world now embraces much of the human population. Systemic Risk This type of catastrophic event can be the culmination of “systemic risk,” a series of cascading effects that can occur under certain conditions in many types of complex systems, ranging from engineered facilities to natural ecological structures to groups of interlocking financial institutions. These cascades, which can start without warning and accelerate rapidly, often cannot be halted until they have destroyed a pre-existing highly stable state of affairs, either evolved or constructed, or have degraded such a state down to a much lower level of performance, where it may languish for a very long time. The term “systemic risk” was first prominently used in a report from the Organization for Economic Cooperation and Development (2003; see also Klinke and Renn 2006). Until recently, it had been taken up only in a small number of technical publications, but now, as a result of the global financial crisis, it has become part of the language of the media and politics. President Barack Obama and congressional leaders in Washington, D.C., began talking publicly about this notion early in 2009 (see, for example, Barney Frank, Chair of the U.S. House of Representatives Financial Services Committee, as quoted in the Wall Street Journal, March 5, 2009, and President Obama interviewed on 60 Minutes on CBS, March 22, 2009). Zhou Xiaochuan, the Governor of the People’s Bank of China, worried about the size of his country’s holdings of U.S. dollar debt, referred in late March 2009 to “inherent vulnerabilities and The Black Holes of Risk | 3 systemic risks in the existing international monetary system” (as quoted in Barboza 2009). A long period of global economic stagnation is one of the possible outcomes of the current global financial crisis, although it is impossible to assign a specific probability to it (see Boone, Johnson , and Kwak 2009). In this regard it should be noted that there are forms of collapse in systemic risk scenarios where the ultimate outcome is not slow recovery but rather either permanent degradation to a qualitatively different (poorer) state, or simply extinction . This is the lesson taught by the collapse in the 1990s of Canada ’s Atlantic cod population, which was triggered by overfishing. It was once a natural resource on such a prodigious scale that the English explorer Bartholomew Gosnold, who named Cape...