The Risks of Interconnectedness

Economists' View has a post this morning on how the unrecognized interconnectedness of the financial sector helped to precipitate the frightening crisis we now seem (hopefully) to be emerging from. It is a fairly complex argument, so I will leave to readers whether they want to follow it through. But the upshot is that while the distribution of risk through various vehicles can and does reduce risk to individual investors under normal circumstances, in more exceptional times, it actually appears to leverage both individual and systemic risk upward because of unrecognized or unanticipated interconnections among borrowers and lenders. Or as the post notes

The people borrowing and lending the money had far more financial interconnections than we noticed or knew about - there was a lot of borrowing and lending among them that was hidden or ignored - and when the higher than expected number of borrowers defaulted, that meant some of the people expecting payments from the lenders were forced into default as well. In the example above, remember that the lenders only had the money short-term, they would need the money later to repay their debts and were just trying to make something on the accumulated balances in the intervening period. But with losses of $1,375 rather than the anticipated gain, they are short on funds and hence must sell assets, call in loans, reduce consumption, etc. to try to accumulate sufficient cash balances to pay what they owe. But not everyone will be able to come up with the money they need, especially as asset prices fall as they are put up for sale, loans dry up, etc., and that will cause more defaults and the problems will spread. Thus, as lenders and everyone else try to rebuild what was lost so they can pay their own bills, that causes even more difficulty, and the result is more defaults on loans, and a process that feeds on itself in a downward spiral of defaults and further problems.

The bottom line is that, while not all can be regulated, regulators need to have a much better sense of the underlying structure of the financial sector, and the potential systemic risks that arise from this structure.