The 'Asian meltdown' hit global markets during the preparation of this feature, upping the stakes in the widening risk debate. In this issue, Jon Ralls speaks with Mark Mobius and Hazel Henderson about the nature of systemic risk, and what can or should be done about it. In Part II, we shall take up their main points, and unpick the models that got us where we are today, in search of new approaches. (INTERNATIONAL FUND STRATEGIES, December 1997 © 1997, Centaur Communications Ltd.)

(Note: This article picks up on themes and arguments that arose in earlier editions of IFS. These features may also be found on this site - see Contents.)

'Risk' is a word on everybody's lips as markets plunge and major institutions fail. As the interdependence of markets and the sheer size of global capital movements increases, the risks within, to and arising from the financial system are undeniably increasing, but is this a problem or an opportunity, and for whom? Is there something wrong with the models or with how they are put into practice? As the battle lines over global liberalisation are drawn, might the polarisation between the free-marketeers and those calling for more regulation and intervention be obstructive in the search for workable solutions?

Everybody talks about risk, but how many people actually understand it? Not many, according to consultant Glyn Holton of Contingency Analysis, whose website contains some three hundred pages on the subject, from basic definitions to complex mathematical equations. Holton believes that risk is one of the most misunderstood concepts in the industry, and offers a series of brain-teasers to illustrate his point - the answers are frequently counter-intuitive.

Holton's definition of risk is all-embracing and deceptively simple: "Risk is exposure to uncertainty... (it has) two components: uncertainty and exposure to that uncertainty". Financial institutions seek to control financial risk, and investment managers specifically investment risk - and some kinds of risk can be reduced simply by research, leading to less uncertainty. However, flawed or excessively narrow perceptions of risk lead to glaring omissions, and some of the greatest risks we all face either cannot be researched or, by the time they have been, the damage may already be done. Holton is very straightforward about the limitations of risk analysis:

"In fnancial applications, quantitative models are often used to try to give objective estimates of risk... While such models are extremely valuable in managing risk, they are just objective estimates based on the model's subjective assumptions... if a model says that there is no risk, does this really mean that there is no risk? What if the model is wrong? This subjective componenent that exists for every objective measure of risk is called 'model risk'."

In a nutshell, the apparent elegance and determinism of economic models leads to their application well outside the bounds of their assumptions - an effect known as the 'fallacy of false concreteness'. This can be applied to the use of risk modelling a fortiori. Holton again:

"... the notion that expected excess returns are proportional to risks taken is simply wrong. This popular notion stems from the Capital Asset Pricing Model which, based on some broad simplifying assumptions, draws the conclusion that the market compensates investors for taking 'systematic risk'. While the theory provides valuable insight into the workings of financial markets, it was never intended to support companies in managing complex or illiquid risks..."

Modern Portfolio Theory (MPT) and its extension the Capital Asset Pricing Model (CAPM) are now under serious attack in both academic and industry literature, but are still in widespread use both systematically and intuitively, so it is important to understand how they arose and what assumptions underlie their conclusions. In particular, they underpin the arguments for diversification, one of the main engines of globalisation.

A critical aspect of CAPM is the result that specific risk can be entirely diversified away, based on the assumption that specific and systematic risk are uncorrelated. But what if they are not? And what if the very process of attempting to reduce specific risk affects systematic and systemic risk? Holton's warnings about use of models outside the validity of their assumptions is spot on, but even he defines a very narrow 'system' within which the models are operating - when he defines 'systemic risk' as risk which may bring down the entire system, he then gives an example of a rogue trader and 'contagion'.

However, the financial system is, in reality, only a sub-system, not just of economics but of all human activity on the planet - neglecting or assuming away causal effects and feedback loops outside that sub-system, and treating them as exogenous shocks, leaves crucial elements out of the analysis. Henderson extends this further, questioning what actually constitutes diversification.

In Part II, in the next issue of IFS, when some of the Asian dust may have settled, we shall look in more detail at the results of Modern Portfolio Theory and the Capital Asset Pricing Model. By expanding on systems-based approaches, we shall examine the implications for mainstream theories of looking at 'model risk', and ask what can be learned from the crisis management endemic in global finance capitalism. With that in mind, in this issue we give the floor to two world-renowned figures, Dr Mark Mobius and Dr Hazel Henderson, for their views on the global risks we face and how (and whether) they might be better managed.

Please follow these links to the interviews with:

• Mark Mobius [still under construction]
• Hazel Henderson

which complete this feature.

Acknowledgements:

The author gratefully acknowledges the contributions of a great many writers, published and unpublished, to the analysis behind this feature. Reproduction, appropriately credited, is encouraged, and feedback welcomed.