Why Strategic Risks Are Ignored

Eight years after the Great Recession, U.S. markets have reached new highs and the economy is close to full employment, but a general unease about the recovery remains just below the surface. In the aftermath of the financial shocks of 2007 and 2008, the Department of the Treasury created the Financial Stability Oversight Council (FSOC) largely to identify systemic risks to the economy and financial markets. Each year for the past six years, the Financial Stability Oversight Council (Council) has published an Annual Report. On June 21, 2016 the FSOC published its sixth report in the series.

“The Council’s annual report is a vital vehicle to publicly highlight potential threats to financial stability and is another example of how Wall Street Reform has improved coordination among financial regulators,” said Treasury Secretary Jacob J. Lew. The Council’s work is centered on 12 threat themes with general guidance for addressing each. The full report can be found at the above link, and the list of 12 threat themes follows below:

• Cybersecurity
• Risks Associated with Asset Management Products and Activities
• Capital, Liquidity and Resolution
• Central Counterparties (CCPs)
• Reforms of Wholesale Funding Markets
• Reforms Relating to Reference Rates
• Data Quality, Collection and Sharing
• Housing Finance Reform
• Risk Management in an Environment of Low Interest Rates and Rising Asset Price Volatility
• Changes in Financial Market Structure and Implications for Financial Stability
• Financial Innovation and Migration of Activities
• Global Economic and Financial Developments

Council membership is represented by the chairs of 14 regulatory agencies including the Secretary of the Department of the Treasury, Jacob J. Lew. The Council is an esteemed committee with its fingers on the pulse of systemic threats that have the potential to impact financial stability. However, if this is the first time you have seen the list, you may not be alone. The first annual report, published in 2012, lists a shorter version of the same threats as the sixth Annual Report.

This begs a question: If the list of potential systemic risks to financial stability has grown larger over the last six years, are U.S. markets ignoring these threats at the risk of a tail event? More importantly, why do we routinely ignore strategically systemic risks?

Has there ever not been a time after a systemic event when you’ve heard from either the news media or market pundits, “we didn’t see that coming?” It is a completely human trait to ignore the risks that are present but have not occurred or that have caused large systemic impacts broadly across financial markets. Each of us experience risks differently, as demonstrated in the Great Recession. While many of the banks and other financial services companies suffered as liquidity dried up, Silicon Valley flourished over the last eight years, funded by alternative capital from the private markets and low-interest rates. Silicon Valley was not the only example. The energy sector single-handedly supported economic and employment growth due to a new technology called “fracking” and low rates from capital markets.

The U.S. markets have become more adroit at adapting quickly to shocks in the marketplace, creating more resilience than in the past. While some industries falter, other industries have filled the space, pushing the economy forward. But we haven’t answered the question. Have systemic risks risen to a point where inaction may lead to shocks that become harder to bounce back from? In other words, as the list of systemic risks grow, does the potential for two or more of these threats occurring simultaneously increase, leading to another “I didn’t see that coming” moment?

I have coined terms to define this question. The first is Risk Deafness. You won’t find a definition for “risk deafness,” because this is the first time it has been used. Risk deafness is the result of ignoring or not believing in the high probability of a threat occurrence. Risk deafness is a form of confirmation bias in that, if the risk does not occur, the lack of occurrence is proof of the low probability of the event. This may partly explain why the FSOC’s list has grown over six years with little meaningful change in the assessment of the threats.

The second term coined to define this question is Risk Blindness. “Risk blindness” is the result of insufficient information or methods to assess how the threat, if it were to occur, would adversely impact you or your organization in a meaningful way. In other words, we are blind to the severity of the threat’s impact. The two biases work together to explain why, when faced with the challenge of assessing uncertainty, we tend to ignore it until it happens and assume that we will be able to successfully address the problem in the same way we have in the past.

It is far easier to ignore threats we hope don’t happen and much harder to think about responding to an event they might occur. It’s even harder when two or more of these threats converge in 100-year events that no one saw coming. “Ignore” and “ignorance” appear to come from the same Latin root. “Ignoring” is the act of avoiding paying attention[i]. “Ignorance” is a state of being uninformed.[ii] Now that you know, there is no longer a reason to ignore these threats.

Eight years after the Great Recession, U.S. markets have reached new highs and the economy is close to full employment, but a general unease about the recovery remains just below the surface. In the aftermath of the financial shocks of 2007 and 2008, the Department of the Treasury created the Financial Stability Oversight Council (FSOC) largely to identify systemic risks to the economy and financial markets. Each year for the past six years, the Financial Stability Oversight Council (Council) has published an Annual Report. On June 21, 2016 the FSOC published its sixth report in the series.

“The Council’s annual report is a vital vehicle to publicly highlight potential threats to financial stability and is another example of how Wall Street Reform has improved coordination among financial regulators,” said Treasury Secretary Jacob J. Lew. The Council’s work is centered on 12 threat themes with general guidance for addressing each. The full report can be found at the above link, and the list of 12 threat themes follows below:

• Cybersecurity
• Risks Associated with Asset Management Products and Activities
• Capital, Liquidity and Resolution
• Central Counterparties (CCPs)
• Reforms of Wholesale Funding Markets
• Reforms Relating to Reference Rates
• Data Quality, Collection and Sharing
• Housing Finance Reform
• Risk Management in an Environment of Low Interest Rates and Rising Asset Price Volatility
• Changes in Financial Market Structure and Implications for Financial Stability
• Financial Innovation and Migration of Activities
• Global Economic and Financial Developments

Council membership is represented by the chairs of 14 regulatory agencies including the Secretary of the Department of the Treasury, Jacob J. Lew. The Council is an esteemed committee with its fingers on the pulse of systemic threats that have the potential to impact financial stability. However, if this is the first time you have seen the list, you may not be alone. The first annual report, published in 2012, lists a shorter version of the same threats as the sixth Annual Report.

This begs a question: If the list of potential systemic risks to financial stability has grown larger over the last six years, are U.S. markets ignoring these threats at the risk of a tail event? More importantly, why do we routinely ignore strategically systemic risks?

Has there ever not been a time after a systemic event when you’ve heard from either the news media or market pundits, “we didn’t see that coming?” It is a completely human trait to ignore the risks that are present but have not occurred or that have caused large systemic impacts broadly across financial markets. Each of us experience risks differently, as demonstrated in the Great Recession. While many of the banks and other financial services companies suffered as liquidity dried up, Silicon Valley flourished over the last eight years, funded by alternative capital from the private markets and low-interest rates. Silicon Valley was not the only example. The energy sector single-handedly supported economic and employment growth due to a new technology called “fracking” and low rates from capital markets.

The U.S. markets have become more adroit at adapting quickly to shocks in the marketplace, creating more resilience than in the past. While some industries falter, other industries have filled the space, pushing the economy forward. But we haven’t answered the question. Have systemic risks risen to a point where inaction may lead to shocks that become harder to bounce back from? In other words, as the list of systemic risks grow, does the potential for two or more of these threats occurring simultaneously increase, leading to another “I didn’t see that coming” moment?

I have coined terms to define this question. The first is Risk Deafness. You won’t find a definition for “risk deafness,” because this is the first time it has been used. Risk deafness is the result of ignoring or not believing in the high probability of a threat occurrence. Risk deafness is a form of confirmation bias in that, if the risk does not occur, the lack of occurrence is proof of the low probability of the event. This may partly explain why the FSOC’s list has grown over six years with little meaningful change in the assessment of the threats.

The second term coined to define this question is Risk Blindness. “Risk blindness” is the result of insufficient information or methods to assess how the threat, if it were to occur, would adversely impact you or your organization in a meaningful way. In other words, we are blind to the severity of the threat’s impact. The two biases work together to explain why, when faced with the challenge of assessing uncertainty, we tend to ignore it until it happens and assume that we will be able to successfully address the problem in the same way we have in the past.

It is far easier to ignore threats we hope don’t happen and much harder to think about responding to an event they might occur. It’s even harder when two or more of these threats converge in 100-year events that no one saw coming. “Ignore” and “ignorance” appear to come from the same Latin root. “Ignoring” is the act of avoiding paying attention[i]. “Ignorance” is a state of being uninformed.[ii] Now that you know, there is no longer a reason to ignore these threats.