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Bubble Value at Risk: A Countercyclical Risk Management Approach, Revised Edition by Max C. Y. Wong

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Chapter 12

Systemic Risk Initiatives

The idea of reflexivity1 and its connection to market crashes and systemic risks has been studied and even published since 1987. Ironically, two decades and three crises have passed, and we still lack the tools to measure and safeguard our financial system from such a danger. Until very recently, most research was focused on phenomenology—explaining but not solving the problem. This chapter describes some key milestones in our understanding of the causes of systemic risk.

12.1 SOROS’ REFLEXIVITY, ENDOGENOUS RISKS

The salient feature of the current financial crisis is that it was not caused by some external shock like OPEC raising the price of oil or a particular country or financial institution defaulting. The crisis was generated by the financial system itself. This fact that the defect was inherent in the system contradicts the prevailing theory, which holds that financial markets tend toward equilibrium and that deviations from the equilibrium either occur in a random manner or are caused by some sudden external event to which markets have difficulty adjusting. . . . I propose an alternative paradigm that differs from the current one in two respects. First, financial markets do not reflect prevailing conditions accurately; they provide a picture that is always biased or distorted in one way or another. Second, the distorted views held by market participants and expressed in market prices can, under certain circumstances, affect the so-called ...

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