Systemic Risk Measures as Holy Grail

Chidem Kurdas

The question of whether private equity and hedge funds pose widespread risk to the financial system is left open in the July 25th report by the US Securities and Exchange Commission on data collected from managers of these investment vehicles.

The main stated goal of this information gathering effort instituted by the Dodd-Frank Act was to gauge systemic risk. However, the SEC suggests it will not tackle that issue – at least not by itself – but rather use the data for other purposes.

So the report states: “While the primary aim of this provision was to create a source of data for the Financial Stability Oversight Council to use in assessing systemic risk, the Commission is using the information to support its own regulatory programs, including examinations, investigations and investor protection efforts relating to private fund advisers.”

The Financial Stability Oversight Council includes the Treasury and various agencies, notably the Federal Reserve, as well as the SEC. What, if anything, they make of the information is unclear.

In fact, the numbers provided in the report suggest the data should not be used to assess systemic risk—to do so would be as misleading as the risk measures used to justify investments in mortgage securities before the property crash.

The data does not indicate anything about systemic risk for the simple reason that it pertains to normal conditions, whereas systemic risk shows up in crises. This is not about the quality of the data, which SEC staff will continue to assess, according to the report. However accurate it may be, the data will necessarily reflect normal times, not the extraordinary situation of 2007-2008.

Thus the finding that 53% of fund net assets can be liquidated in seven days or less is almost certainly accurate—but only as long as markets function as they usually do. That says nothing about selling assets in a crisis situation. Ditto for other findings. Therefore using such information to supposedly appraise systemic risk can only lead to confusion.

In The Black Swan Nassim Taleb made a powerful case that we trip ourselves up by presuming to calculate and control the risk of outliers. His criticism of the standard risk measures used in the financial industry has led to some beneficial soul searching in the industry.

In the meantime regulations instigated with the rationale of preventing future financial crises have pushed government entities to produce information that can only mislead when applied to systemic risk. But what else can you expect from that regulatory fraud, Dodd-Frank?

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