Is it true that there are "no known systemic risks" present in the markets?

Risks lurking in the dark

The danger is in what we don’t know!

2022 was a tough year. Everyone appears to be on the edge and on the lookout for risks lurking around. First there was the inflation scare, in the middle there was also a stagflation scare, and now the recession scare. Directionality seems to be all over the place and market doesn’t seem to be able to make up its mind. In times like this some people see crisis all around, while there are others who make claims such as:

“There are no systemic risks out there”

or,

“We don’t see a huge downside since we don’t see any systemic risks out there”

This is not necessarily typical of this time around, we have seen this movie before. Historic experiences suggest that when the systemic risks come out in the open, people who tend to relay statements like the ones above are taken up by surprise. One day it’s not there, and the next it is there. Panic ensues and these people go into the hiding, and then a separate group of people come out into the limelight - those who claim to have seen it coming. The switch typically is very rapid - the “validity curve” of these types of statements typically conforms closely to a step-curve. The statement remains valid (almost 100% valid) for a period of time, then the risk comes out in the open, and then it is proven in a relatively short period of time, and then the statement is rendered invalid.

Is it ever possible to find systemic risks ahead of time?

This fact presents an interesting question - “is it ever possible to find systemic risks ahead of time"? The answer interestingly is - “yes” (for information-based systems, which a market-system is), based again on historic experience, it is possible to find systemic risks ahead of time. However, it is very expensive to find systemic risks, and it is typically also expensive to fix them. But, once found they can be way more expensive to leave them just like that.

The potential severity of impact of systemic risks typically are so high that mitigation costs would always tend to be justified by the potential cost in case of risk materializing. Thus, whenever the risk is identified, it would typically activate mitigation activities, and the risk would soon get mitigated/eliminated. Thus, the average life-span of a known systemic risk would be relatively short. Systemic risks either would not be found/known (as they are complex or expensive to find) or as soon as they are found, they will be taken to the mitigation block, as leaving them unmitigated typically is not a viable option.

In probabilistic terms, for a system with a high probability of survival, a systemic risk has high probability of either being not know/found or having been mitigated (thus no longer a risk to the system), and a very low probability of being known and not yet mitigated. Thus, in the realm of systemic risks, the danger is in what is in the dark (not known or not knowable).

If the systemic risks related to the housing crisis back in 2005 to 2008 were known and widely accepted to the accurate degree of probability and impact (thus qualifying to be a systemic risk), mitigation plans would have been activated to resolve those, thus moving us away from a GFC. Lehman Brothers may not have collapsed or its collapse may not have had the impact it had on the markets. Other examples also apply.

Conclusion

To conclude, a statement like “there are no known systemic risks present at the moment” is a meaningless one. The statement is almost always supposed to be true. That is by design. And if a system existed that allowed for systemic risks to linger around for longer, the design of the universe is such that those risks would eventually bring down the system in question. As a result, these types of “tolerable” systems would cease to exist.