Black Holes of Risk

By William Leiss

Table of Contents

Chapter I:  Black Holes of Risk

Chapter II:  Systemic and Super-Systemic Risk in the Financial Sector

Chapter III:  Controlling the Downside

©William Leiss 2010

Forthcoming October 2010 from

The University of Ottawa Press

I

Black Holes of Risk

Finally, 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, p. 335)

Two important ideas are contained in the passage quoted above.  First, in the process of seeking to control the risks we recognize and understand – risks that have been well-described by 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, ones we are utterly unaware of or misunderstand.  Second, there is the possibility that, in substituting obscure risks for better-known ones through our carelessness in risk management, we may actually increase, rather than diminish, the adversities that can happen to us from the sum of all the risks we face.

Two main theses related to these ideas are explored in the opening and closing sections of this book and are illustrated by the case study of risk in the banking and financial sector that is sandwiched between them.  One thesis is that we have begun to use our 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 this:  By throwing caution and precaution to the winds in making such bets, we are exposing ourselves 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 so over a very long time-frame.  As globalization proceeds apace, drawing all nations and regions on the globe 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.

This type of catastrophic event is referred to as a “systemic risk.”  Until recently this term had been used only in a small number of technical publications, but now, as a result of the global financial crisis, it has quickly become part of the language of everyday life.  President Barack Obama and Congressional leaders in Washington began talking publicly about the notion early in 2009, and 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 systemic risks in the existing international monetary system.”¹ This type of risk, which will be discussed more fully in the following chapter, refers to 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 interlocked 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, and until they have degraded such a state down to a much lower level of performance, where it may languish for a very long time.²

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.³ 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 either permanent degradation to a qualitatively different (poorer) state, or simply extinction.  This is the lesson taught by the collapse of Canada’s Atlantic cod population in the 1990s which was triggered by overfishing.  This was once a natural resource of such prodigious scale that the English explorer Bartholomew Gosnold, who named Cape Cod, Massachusetts, remarked at the beginning of the seventeenth century, as he gazed into the coastal waters from his ship, that he imagined he could walk to shore on the backs of these great fish.  In 2008 two Canadian fisheries scientists made this prediction about the future of the Atlantic cod in the Gulf of Saint Lawrence:  “We conclude that at the current level of productivity, this population is certain to be extirpated within 40 years with no fishery removals and within 20 years with removals at the current low level.”  They add that they regard their projections as “likely overly optimistic.”⁴

Suddenly, in late 2008, citizens and their political leaders around the world woke up to the realization that the social and economic order they thought they understood possessed a set of dangerous and unstable features of which they were heretofore completely unaware.  What is not yet clear is whether they will come to realize that the very tool designed to protect them against excessive risk-taking – namely, the so-called “risk management paradigm” – had been instrumental in subverting prudent financial policy and turning their productive economies into little more than high-stakes casinos.  They can be excused this failing, since most of them had not been invited to play at the gaming tables.  In the final chapter I will examine the question whether all of us have learned enough to prevent a repeat of this particular farce, or similar ones yet to be invented.

[1] The Wall Street Journal, 5 March 2009 (Barney Frank, chair of the House Financial Services Committee, on systemic risk regulation); President Obama’s interview on CBS’ “60 Minutes,” 22 March 2009, available on YouTube; Chinese official quoted in Barboza 2009.

[2] The phrase is used in Chapter 1, “Emerging Systemic Risks,” of a report from the Organization for Economic Cooperation and Development (OECD 2003), but the concept is not developed there; see also Klinke and Renn 2006.

[3] Boone, Johnson and Kwak 2009; this scenario envisages a “Japan decade” (or longer) of economic stagnation on a global scale; in graphical terms, it is represented as an “L” shape.

[4] Swain and Chouinard 2008; I owe this reference to Professor Jeff Hutchings of Dalhousie University.  On the collapse of the cod fishery, see Hutchings et al. 1997.