Economic Crisis Was Born, Ultimately,

¶ … economic crisis was born, ultimately, of a failure in risk management. The multitude of bank failures -- nearly 100 in 2009 alone -- is largely the result of banks carrying too many so-called "toxic assets." Some of these toxic assets were in the form of subprime mortgages in arrears and others were in the form of derivative instruments with underlying value tied to the risky mortgages. Whichever the case, the end result is the same. The assets are rendered worthless, the bank struggles, and the substantial harm is done to the economy. The SEC is currently investigating whether or not boards of some banks failed exercise sufficient oversight into the level of risk taken by the banks in light of the crisis.

That the current crisis was allowed to evolve in the manner in which it did by so many financial institutions illustrates some of the weaknesses in risk management in the banking industry. This begs the question as to what the current state of risk management actually is. The system has struggled so substantially in the past year and a half in part because the subprime crisis added significantly to systemic risk. The entire economic system had its risk level increased by these mortgages and the derivatives created from them (Weisman & Paletta, 2009).

Classic risk management has focused on non-systemic risk. It is felt that diversifying away this risk will be substantial for investors, portfolios and the economy as a whole. However, greater integration of financial markets has revealed that the level of systemic risk has risen to a level with which regulators are uncomfortable. As such, risk management at financial institutions has failed to keep up with the times but so too has risk management at the regulatory level.

This paper will examine the state of risk management from two perspectives. The first is by examining the degree of interdependence of key markets and indicators. Subprime mortgages were not by any means a major component of the total market, yet when they crashed, the high degree of market interdependency led to sharp declines in the value of many companies, not just banks that happened to be burdened with toxic assets. The methodology will therefore begin by comparing the interdependence of different markets over time. This will reveal whether or not sectors and global markets have become increasingly correlated over time. It is hypothesized that they have, which in turn has contributed to an increase in systemic risk as such interdependence reduces the value of diversification.

The second component of the paper will examine what is being done with respect to reducing systemic risk. This component will include an overview of the traditional theory and a review of the current literature on systemic risk. The crisis has spurred new work on systemic risk, including work specific to financial institutions. Huang, Zhou and Zhu (2009) have developed a framework, for example, to analyze systemic risk at financial institutions. Such methods may provide insight for regulators, boards of directors and regulators that will allow them to curtail risk before it manifests into full-blown economic crisis.