The Definition of Systemic Risk
Clearly, the need to both define and manage systemic risk is at the heart of regulatory reform. Over the course of the debate, the term "systemic risk" has been mentioned so often it is easy to conclude that there is a universal understanding of the term, but this is not the case.
This is a problem the world over. As the Commission liaison to the Council of Securities Regulators of the Americas (COSRA), last week I participated in our bi-annual meeting, and we spent a significant amount of time discussing systemic risk and how it should be defined and regulated. There was no obvious consensus. Additionally, in a report prepared in October 2009 for the G-20 and Central Bank Governors, it was found that twenty-eight countries did not have a legal or formal definition of what constitutes systemic importance.
Other than a general understanding that systemic risk is risk that has widespread impact, there seems to be little agreement of the types of events, or the nature of activities, that could actually cause the kind of market meltdown that a systemic risk regulator would be tasked with monitoring and preventing. For example, some countries focus on the impact of potentially systemic institutions, markets, or instruments on the financial system, while other countries consider the impact on the real economy, as opposed to the financial sector, to be the key consideration. The possible reasons for these differences are difficult to discern.
Regulators are not the only ones focused on the concept of systemic risk, we are seeing it in other contexts, including shareholder proposals.
In fact, SEC staff recently denied a company's request to exclude a shareholder proposal from its proxy materials because it focused on a significant policy issue - systemic financial risk. The specific proposal in question asked for a report of the company's collateral policies for over-the-counter derivatives trades and its procedures to ensure that collateral is maintained in segregated accounts and is not re-hypothecated. The proposal indicated that it was intended to allow shareholders to adequately assess the company's sustainability and overall risk, in order to avoid future financial collapses. Given the role of collaterization and re-hypothecation practices in managing systemic financial risk, as well as the company's significant derivatives activities, staff was unable to agree with the company that this particular proposal could be excluded as relating to a matter of ordinary business. Rather, staff concluded that the proposal focused on a significant policy issue - systemic financial risk.
From shareholders to people around the world, there is widespread agreement that the global financial system has demonstrated vulnerability to systemic risk. However, how one defines systemic risk matters in terms of the resulting regulatory structure. It seems that identifying systemic risk is akin to the often referenced statement by Justice Potter Stewart about obscenity: "I know it when I see it."This lack of a common understanding is important because how you define systemic risk directly influences your ideas about how the financial regulatory system should be structured and operated.
