Systemic risk -It is hard to define

The government wants to control or diminish systematic risk. Sounds like a great idea. No more crises like what we saw last year. This is something the world financial community should get behind right now before it is too late. Except there is a problem with the systematic risk issue. We don't know how to define it. Gerald Dwyer at recent Atlanta Fed conference showed that the very definition is difficult to state in a short sentence.

The G10 Report on Consolidation in the Financial Sector (2001) suggested a working definition:

"Systemic financial risk is the risk that an event will trigger a loss of economic value or confidence in, and attendant increases in uncertainly [sic] about, a substantial portion of the financial system that is serious enough to quite probably have significant adverse effects on the real economy."

So big financial loss that effects the the rest of the economy will do it. But how big? Did the LTCM failure have a real effect? Hard to say. The LTCM problem was triggered by the Russian currency devaluation and bond failure. Was that the systemic risk? Was the Asian crisis a systematic risk or just a emerging market failure?

Here is another

Even George G. Kaufmann and Kenneth E. Scott (2003) define "systemic risk" in imprecise terms:

"Systemic risk refers to the risk or probability of breakdowns in an entire system, as opposed to breakdowns in individual parts or components, and is evidenced by co-movements (correlation) among most or all the parts."

What is a system breakdown? If there is a common factor, then we would expect that there would be correlated returns.

Finally a third,

Darryll Hendricks (2009), who is a practitioner, suggests a more theoretical definition from the sciences in which the term originated:

"A systemic risk is the risk of a phase transition from one equilibrium to another, much less optimal equilibrium, characterized by multiple self-reinforcing feedback mechanisms making it difficult to reverse."

Yes, the phase transition will be easy for the general public to understand as the reason for some massive government action. The multiple reinforcing feedback mechanism simply means that the market herd is all heading out of some asset classes at the same time.

A correlated dislocation of price from value may be more informative, but then you have the problem of having to determine what is fair value. Until we have a good workable definition of systemic risk we should not make any hasty change in regulation.