How to Address the Quandaries of the Financial System
How do we address the quandaries of the financial system? Numerous experts assert their knowledge about rendering the financial system advantageous to us—no crises, robust returns on investments, and formidable economic growth. Hopefully, their pronouncements shall materialize.
While we may desire to have our cake and partake of it, there always exists a trade-off between safety and risk. All simplistic solutions highlight the most conspicuous exogenous risks, yet they disregard the sinister forces that underlie tail risks and crises. Before it is too tardy, we possess intelligent methodologies to attain the desired outcomes. These matters shall be expounded upon in meticulous detail, distilled into a handful of principles that propel the financial system towards optimal functionality.
We must acknowledge that the true peril arises from endogenous risks, concealed malevolent forces that elude our detection until it is too belated. All too frequently, we neglect endogenous risk and concentrate our endeavors on the deceitful path within the garden—the visible exogenous risk. Endogenous risk represents the fundamental impetus behind instability and loss. We excessively employ leverage, harboring the belief in boundless liquidity within an interconnected financial system, upon which the system’s existence fundamentally hinges. Each individual vigilantly safeguards themselves and relies upon the promise of governmental rescue. We fixate solely on the apparent aspects and disregard the concealed factors; we concentrate exclusively on controlling each entity independently while remaining heedlessly indifferent to the external world. We all yearn for the perpetuation of halcyon days within the market.
These fundamentals constitute the crux of every crisis. The predicament for any risk-conscious individual is that the underlying causes of loss and instability prove arduous to redress. Evaluating endogenous risk is a challenging, if not insurmountable, task. In the years preceding 2008, no one comprehended the perils of subprime mortgages being funneled into structured credit products until it was too late, regardless of any subsequent actions.
Endogenous risks lie dormant for years, or even decades, until an external shock awakens them.
While presently, we possess only a few well-understood fundamental factors capable of triggering a crisis, the trigger points for crises are limitless. The key discrepancy between triggers and root factors lies in visibility—triggers are plain and obvious, whereas root factors remain obscure. It is this visibility that leads us astray, for what triggers a crisis today may elude us tomorrow. Instead of fixating on triggers, we ought to direct our attention towards the root causes of crisis and poor performance—endogenous risk.
Another principle involves exercising caution against false resilience. It is facile to construct a framework that furnishes us with desired outcomes. All appears well because that is what the Risk Dashboard conveys to us. Meanwhile, the endogenous risk monster taunts us. If the risk dashboard proclaims low risk, we yearn to assume greater risk. Yet, this represents false resilience. The crisis of 2008 did not arise solely from the audacious risk-taking behavior of bankers in that specific year. Its genuine source can be traced back to their audacious risk-taking behavior during the frenetic years of the early 21st century. By 2008, there was naught to be done except mitigate the worst consequences. We were already embroiled in crisis. When adverse events transpire, we seek to derive wisdom from them, discerning what went awry so as to prevent its recurrence—commonly referred to as “remedying the situation post facto.” Such endeavors also foster a spurious sense of resilience. Destabilizing forces amass in shadowy realms, where no one casts their gaze, thus ensuring that the subsequent crisis shall manifest elsewhere.
The primary instigators of false resilience are the micro risks we gauge, not the types of risks that concern us most. The quandary lies in the risk meter, that seemingly magical device which, when delving into the depths of the financial system, furnishes an indication of the level of financial risk. Daily financial oversight, risk management, and portfolio administration increasingly hinge on such risk meters. Why? Because they are deemed scientifically objective and assist decision-makers in dissecting intricate issues into an array of precise figures on a risk dashboard.
This is where the quandary arises. The risk meter is not as scientific and objective as its proponents believe. It pales in comparison to precise scientific instruments like thermometers.
For most financial risks, even with concerted efforts from numerous individuals, we are unable to implement a feedback mechanism of such caliber.
Different focal points necessitate distinct conceptions of risk—what constitutes risk is contingent upon our area of focus.
We must remain vigilant against false resilience. Genuine resilience necessitates concentrating on the root causes of loss and instability, rather than measuring risk or rectifying past mistakes.
