Endogenous Risk and Dangers to Market Stability

Abstract

There are various methods and models where one can quantify risks and try to predict future correlations. However, the flaw with any given financial model is that certain assumptions must be made, and when the market deviates too much from these assumptions, then the model falls apart. Under traditional valuation methods, risk is divided into systematic and unsystematic risk. But there is another way to look at risk, and that is whether it is exogenous or endogenous. Exogenous risk represents risks found outside the financial system, and is taken into account when doing fundamental analysis. Endogenous risk, on the other hand, is the risk found within the financial system itself. This type of risk is the most dangerous, and is often overlooked or not taken seriously enough by advisers and financial planners. Endogenous risk comes from aberrations and shocks that are generated within the financial system itself, which then have a ripple effect throughout the financial markets. It can cause extreme volatility (and losses) for investors and lead to behavior that may not be in the best interest of a client, namely selling when prices are depressed. The number of events occurring because of endogenous risk is increasing, which should be a source of concern. The emergence of financialized capitalism, the increase in speculation and decrease in investing, the growth of derivatives and use of leverage, the practice of shadow banking and lack of transparency, and the existence of institutions that are “too big to fail” all increase the likelihood of an endogenous event. Given the potential impact of endogenous risk, and the threat it poses, it should be taken into account when putting together financial plans and constructing client portfolios.