Systemic Risk

David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok’s articles and financial market commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a frequent contributor to CNBC programs. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).


Systemic Risk
March 16, 2009

“Systemic risk is the risk imposed by inter-linkages and interdependencies in a system or market, which could potentially bankrupt or bring down the entire system or market if one player is eliminated, or a cluster of failures occurs at once.

Systemic financial risk occurs when contingency plans that are developed individually to address selected risks are collectively incompatible. It is the quintessential “knee bone is connected to the thigh bone…” where every element that once appeared independent is connected with every other element.”

Source: AIG draft document dated Feb. 26, 2009, ABC News and Barry

Ritholtz website, .

We are almost two years into this developing financial mess. Yes, it has been two years since Fed Chairman Bernanke stopped using the word contained in his public remarks when he described the state of things in the money world.

Much of the current activity focuses on the structure of the massive and unprecedented federal bailout of the financial firms and financial system. The bailout is a response to the elevated and intensified level of systemic risk now widely accepted as prevalent and sufficient to justify these unprecedented federal financial actions. The label “systemic risk” is the latest in prominent titling of the state of affairs. Fed Chairman Bernanke’s recent speech elevated the term to “best seller” status.

There are many definitions of systemic risk. In fact it is one of the least precise terms in the current lexicon. It seems to be defined like pornography: “you know it when you see it.” AIG’s self-serving definition is sufficient for this commentary.

Readers may recall our frequent statements about how the failure of Lehman Brothers is the seminal event of our generation. Unpredictably, one of the Federal Reserve’s primary dealers and “AA” corporate credit bankrupted six months after the Fed’s new tools were implemented following the Bear Stearns affair in March of last year. Those Fed tools were specifically designed to support the primary dealers and avoid a repetition of Bear Stearns. Instead, they failed miserably. The “unexpected and unthinkable” happened and the world’s financial environment morphed from an idiosyncratic risk model to a systemic risk model.

History shows that it takes some kind of shock to trigger a systemic risk event. The shock must be bigger and more profound than anticipated. If it is already anticipated both as to size and to type of event, it does not qualify as a shock.

Note that lip-service identification of a systemic risk is not anticipation and preparation. We have heard discussion of bird flu systemic risk for over a decade. Most people on the planet do not act as if they believe it will occur. Thus the precautions are lacking because people are complacent. A pandemic that kills millions of people and overwhelms our health systems will qualify as a systemic risk event. The global financial results would be catastrophic.

Also note that the 9/11 attacks by Al Qaeda had elements of systemic risk in a geopolitical sense, but the risk was contained in a financial sense. The Federal Reserve’s payments system was buried under rubble between the twin towers, yet no meltdown of payments occurred. Payrolls were met throughout the country. Settlements were completed. Defaults did not overwhelm the financial system. The Fed’s contingency plans were placed to avoid risk with Y2K; they mostly worked after 9/11. The Atlanta Fed was the backup for the New York Fed and functioned well. The Fed also massively infused reserves, and its balance sheet expanded rapidly at that time. 9/11 was a tragedy and changed the military and political dynamic of the world. It was not a financial systemic risk event because, unlike in the case of Lehman Brothers, the Fed’s preparations for contingencies worked.

Lehman was arguably the financial shock of our generation. Here are some others that had financial implications. The last generation encountered a shock with the outbreak of the Middle East War in 1973, when the price of oil quadrupled and interest rates subsequently reached the highest levels they had seen since the Civil War. The generation previous to that one received its shock with the Japanese bombing of Pearl Harbor in 1941. And the preceding generation experienced its shock in December, 1930 when the Bank of the United States failed and 500,000 businesses lost their bank deposits. As we can see, financial systemic shocks are mostly but not always the result of the failure of a financial firm.

We know we have a financial systemic risk event when the aftermath is a changed paradigm. Size matters. In systemic terms it simply has to be big.

There were numerous small and rural bank failures in the Depression era. They were idiosyncratic events. But when the New York banking regulators and banking community did not save the Bank of the United States, they morphed that crisis into a global systemic event. Similarly, we are seeing bank failures regularly in the US during this crisis. They are being resolved by the FDIC and do not singly rise to the level of a systemic risk event. Even IndyMac’s failure was an idiosyncratic risk event.

After Pearl Harbor, the United States engaged in global war, levied enormous taxes to fight it, and borrowed huge sums to finance it. Debt exceeded 100% of GDP by the time the war ended. Annual inflation exceeded 10% during the war, while the interest rate on 90-day Treasury bills was maintained at 3/8 of 1% for four years. The twelve regional Federal Reserve banks bought unlimited numbers of T-bills to sustain the rate. The size of the Fed’s balance sheet was virtually ignored.

The argument over whether or not some organizations are “too big to fail” is really a silly one, in my view. There are plenty of folks who disagree with this statement, and I expect the emails will commence shortly. In our view size matters greatly. It is one of the distinguishing characteristics between an idiosyncratic risk event and a systemic risk event.

Remember, after a shock the paradigm shifts from idiosyncratic to systemic. That is what happened when Lehman failed. The damage from Lehman was huge. Global stock markets lost trillions in value in five weeks during the waterfall selloff. Credit spreads widened to levels never contemplated, and many sectors of the financial markets ceased to function. Liquidity disappeared. New issues were halted and the notion of markets as a vehicle to raise capital ceased operation. Bond spreads to Treasuries astronomically widened. Treasuries rallied in price to the point where T-bills were yielding zero interest. A global flight to quality ensued.

Lehman triggered massive and “hurry-up” new monetary tools. They were and are being deployed by the central banks of the world. Our Fed is now proactive and thinking systemically; prior to Lehman it was reactive and thinking only in idiosyncratic terms. An example is the Term Auction Facility (TAF). It didn’t exist before the Lehman failure; it is now huge and has succeeded in reversing the disappearance of liquidity. At first the Fed was tepid with the TAF. They were still trapped by idiosyncratic thinking. Fortunately, they quickly realized their error and enlarged the TAF massively. We saw a similar successful response with the commercial paper facility and with the money market fund liquidity guarantees.

We need to note that it is important to observe how each central bank’s monetary policy is becoming coordinated globally. It has to be that way if policy is to succeed in dampening systemic risk. Governments have become the only credible guarantors of payments. And that is most effective when policy positioning is such that the currency used for payment is that of the guarantor.

Now systemic risk has entered the daily discourse. Once that happens we can expect it to start to subside. Policy pronouncements from the Fed, Treasury, and the Obama Administration are becoming more coordinated and are starting to be believed. Simply put, “there will not be another Lehman.” Other countries like the UK and monetary unions like the ECB are applying their own similar prescriptions.

No one will be able to announce it when systemic risk subsides. Market-based indicators of risk will show it as a trend. The VIX will fall. Credit spreads will narrow. Dysfunctional sectors of the financial markets will resume functionality. The diminution of systemic risk occurs over time and only as events gain clarity and agents accept credibility.

In the United States, there is a compelling necessity to heal and there is massive distrust of the political process. Only in the last week has our new, young, inexperienced president learned that his role must include forward-looking positive statements. Our Treasury Secretary is wounded both from his pre-confirmation revelations and because his attempts to speak clearly have resulted in obfuscation. Sadly for him and for the country, Geithner has become the financial world’s whipping boy.

My colleague Bob Eisenbeis asked, “If a systemic event is an unanticipated shock with broad-based consequences, how does this help us set out what the parameters of power should be for a systemic risk regulator?” Bob identifies a key element that is currently under discussion in Washington. Proposals for a systemic risk regulator are circulating now. Congress will soon hold hearings on this and on a new federal insurance regulator that will be designed to replace the 50 states. Part of this initiative is due to the displeasure being voiced at the existing structure used to address the current recipients of financial aid. An example of this displeasure is found in the remarks of Kansas City Fed President Tom Hoenig. He minced no words in his March 6 speech: “If an institution’s management has failed the test of the marketplace, these managers should be replaced. They should not be given public funds and then micro-managed, as we are now doing under TARP, with a set of political strings attached.”

Unlike TARP under both Paulson and Geithner, credibility has been maintained at the FDIC. Global agents trust the safety of the insured bank deposit and the pledge of Sheila Bair’s agency to honor its commitments. Runs on banks have stopped.

The Fed could be much more transparent in its public depiction of policy. Communication from the Fed is still arcane and confusing. But the Fed is succeeding in the application of policy even though it is failing at communication. My colleague Bob Eisenbeis will have more to say about this in his forthcoming series on AIG. The Fed’s policy is working and professionals are gaining the ability to rely on it.

We are still in very uncertain and high-risk times. Our current deployment is about 50% stocks, 50% bonds, and zero cash. This is 20 points under the normal 70% stock weight and 20 points above the normal 30% bond weight. We have sold Treasuries. For individuals we emphasize the terrific bargain available in the tax-free municipal bond sector. We advise that bond selection must be done skillfully. The days of relying on bond insurers and credit-rating agencies are over. On the taxable side we emphasize higher-grade corporate credits and taxable municipal bonds.

Readers are welcome to visit our website,, for our comments on global allocations and on various monetary and regulatory forensics or lack of same. We particularly thank former St. Louis Fed President Bill Poole for giving us permission to present his recent speech on bailout programs to our readers. See .

Bob Eisenbeis’ comments on AIG are forthcoming. John Mousseau, Peter Demirali, and Bill Witherell will be weighing in as well.

We are in Paris next week as Program Chair of the Global Interdependence Center,, with a worldwide discussion of the food and water and global stability issues. Most assuredly, we are eager to moderate the panel on March 26 at the Banque de France with five central bankers, as we discuss monetary policy and how it is applied in this crisis period. The lineup of speakers in Paris is global and first-rate. The GIC partner and host in Paris is the Banque de France; and its Governor, Christian Noyer, has been very supportive of this worldwide dialogue initiative. Delegates will come from around the globe. There are a few seats still available in the GIC delegation. If anyone wishes information, call 215-898-9453 and ask for GIC director, Erin Hartshorn. Cumberland Advisors is a proud sponsor of the GIC.

We are adding a technical endnote to this commentary in the framework of a discussant’s comments. Readers may note that at Cumberland we use an internal vetting process for our Commentaries.

Bob Eisenbeis offered this observation while wearing his macroeconomist hat: “In macroeconomics, the current lexicon talks about shocks which are unanticipated events. But in no way are those shocks regarded as systemic events. They talk about positive shocks, such as an unanticipated upsurge in productivity; and we could talk about negative shocks, such as an abrupt one-time upward shift in energy prices. Again, this would be regarded as a negative shock but not a systemic event. Both the positive and negative shocks would meet your definition of a systemic event. So, I am not sure how to process your view on systemic risk. A key element in your argument seems to be that Lehman’s failure was an idiosyncratic event that became a systemic event because of the Fed’s failure to save it, which then had broad consequences for the entire financial system.”

Bob added, “One idea might be to draw on the parallel concept of “jump risk.” That is, asset risks may be uncorrelated until a shock occurs, and then they suddenly become correlated and have unanticipated consequences and negative spillover effects to all investors in those assets. For example, in normal times a geographically diversified portfolio of mortgages would be risk-reducing, because a problem in one local market is independent from events in other local markets. But then an adverse shock occurs to the macro economy, and suddenly housing prices begin to decline across all local markets, meaning that the risks are now highly correlated and destroy the portfolio.”

Kotok response: I think Bob’s point about jump risk has validity. Global markets were relatively uncorrelated preceding the Lehman failure. During the five-week waterfall sell-off following Lehman, nearly all stock markets in the world declined in a highly correlated manner. This action coincided with the spiking of credit spreads and seizure in many market sectors. As the definition of systemic risk evolves, we expect that the application of ”jump risk” may be an additional consideration.

David R. Kotok, Chairman and Chief Investment Officer, email:

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