Systemic Risk and Risk Management: Overview and Approach

Abstract

This paper is a compilation and expansion of two earlier papers, one on systemic risk and the other on strategic risk management. Part 1 of the paper proposes a definition and assessment methodology for systemic financial risk that was inspired by systems accident research. Sociologist Charles Perrow found that industrial, aviation and marine systems are prone to failure if those systems are interactively complex and tightly coupled. Using that framework as a starting point, financial crisis research led to the definition of systemic financial risk as a function of financial complexity and excessive leverage. The paper presents practical criteria for applying these parameters, and then profiles the triggering mechanism of systemic financial risk — financial contagion — in a behavioral context consistent with my framework. Part 2 of the paper presents an approach for identifying the weak signals of developing ambiguous threats, such as systemic financial risk manifestation, as well as an approach for economically managing the risk of enterprise-threatening loss. Both parts of the paper are readily assessable to a broad array of financial agents and researchers.