FINANCIAL REGULATION, INNOVATION COMPLEXITY, AND SYSTEMIC RISK

Abstract

There are no models for financial systems of systems (SoS). Without a model for a financial SoS, systemic risk cannot be uniformly interpreted by practitioners, law makers and economists. The recent financial turmoil and the interdependence of components have exasperated the need for modeling financial systems as a SoS. The current national dialog about the crisis in the financial system has been dominated by the traditional forces that have shaped the economic and financial paradigm. However, it should come as self-evident that the system's perspective on a system such as the financial system should add value and credibility to the analysis, synthesis, and policy changes pertaining to this vital system. The financial system has one foot in social sciences and the other in quantitative sciences. A reductionist approach to understanding the financial system produces locally valid approximations by ignoring systemic complexity. However, it is the systemic complexity that causes the mischaracterization of risk which, left undetected, accumulates in the SoS and creates a systemic risk. This paper provides a model for financial SoS and an associated systemic risk measure and connects the field of systemic reliability to systemic risk.