What is systemic risk?

Summary

This video explores the concept of systemic risk, illustrating it through the unexpected swaying of London's Millennium Bridge. The bridge’s swaying was caused by a feedback loop, where individual pedestrians, trying to stabilize themselves, made the bridge more unstable. Similarly, in financial markets, systemic risk arises when individual actions, like algorithmic trading, can trigger cascading effects that destabilize entire systems. The video stresses the importance of understanding these hidden risks and the need for careful policy-making to prevent financial crises, which often result from collective behavior during times of market stress.

Takeaways

• 😀 Systemic risk is a concept that few people understood before the financial crisis, and it’s best illustrated by a real-world example: the Millennium Bridge in London.
• 🌉 The Millennium Bridge swayed violently after opening because of the collective movement of pedestrians, a phenomenon that engineers did not anticipate.
• ⚖️ The swaying of the bridge was caused by a feedback loop: pedestrians unconsciously synchronized their walking, which amplified the swaying, just as systemic risk can amplify in financial markets.
• 🧑‍🤝‍🧑 Individuals acting in the same way can destabilize a system, even if each individual is simply doing what seems rational for themselves.
• 🔄 The 2010 Flash Crash in financial markets provides an example of systemic risk. Algorithms triggered a massive market downturn due to their programmed responses to increasing market activity.
• 💻 Algorithms, which act in a rational way individually, can cause widespread instability when many of them act together in the same direction.
• 📉 In the Flash Crash, the algorithms initially sold, causing prices to fall, which led other algorithms to sell more, exacerbating the crash. Eventually, real investors intervened, and prices recovered.
• 📊 Systemic risk occurs when individuals, or algorithms, all act in the same direction at the same time, leading to a crisis that might not have been predictable beforehand.
• 📅 Financial crises are difficult to prevent because the details of each crisis are unique, and we only truly understand the causes after the fact.
• 🎯 The key lesson from the Millennium Bridge and the Flash Crash is to be cautious of feedback loops and the collective behavior of people or systems, as they can create instability when least expected.

Q & A

What is systemic risk?

Systemic risk refers to the risk of a breakdown in an entire system, often due to the interactions between smaller components that amplify negative outcomes. In financial markets, it can occur when individual actions, like selling assets, combine in such a way that they cause larger, widespread problems.

How does the Millennium Bridge incident relate to systemic risk?

The Millennium Bridge incident demonstrates systemic risk through the synchronized movement of pedestrians. When people walked in lockstep, their individual actions amplified the bridge’s swaying, leading to instability. This is similar to financial markets, where individual actions, when combined, can lead to larger systemic failures.

Why did the Millennium Bridge sway unexpectedly after it was opened?

The bridge swayed because the engineers didn’t anticipate that pedestrians, as they crossed, would move in a synchronized manner, creating a feedback loop. This group behavior amplified the small movements caused by a gust of wind, making the bridge unstable.

What role did pedestrian behavior play in the Millennium Bridge incident?

Pedestrian behavior played a critical role because their steps, although individual, became synchronized, which caused the bridge to sway more. This collective movement created a feedback loop that intensified the instability, illustrating systemic risk.

How can individual actions in a system lead to larger problems?

Individual actions, when performed in large numbers or in sync, can interact in ways that amplify small effects, creating large-scale issues. On the Millennium Bridge, individuals were acting to stabilize themselves, but collectively they made the bridge more unstable. The same principle applies to financial markets, where many investors acting similarly can cause market crashes.

What happened during the 2010 Flash Crash, and how is it similar to the Millennium Bridge incident?

During the 2010 Flash Crash, automated trading algorithms caused a rapid drop in asset prices by selling more assets as market activity increased. This triggered further sales in a feedback loop. Like the bridge incident, it was the collective behavior of these algorithms, all acting similarly, that led to a large-scale crash.

What role did algorithms play in the 2010 Flash Crash?

In the Flash Crash, trading algorithms played a key role by responding to market activity with increased selling. As prices fell, the algorithms continued to sell, causing even more dramatic price drops. This behavior mirrored the systemic risk seen in the Millennium Bridge incident, where small individual actions escalated into a larger problem.

What can be learned from the interaction between pedestrians on the Millennium Bridge and traders in financial markets?

The main lesson is that individual actions, though rational when considered separately, can have unintended collective consequences when many people or systems behave in the same way. In both the Millennium Bridge and financial markets, collective behavior can lead to instability and larger systemic risks.

Why is it difficult to prevent financial crises?

Financial crises are difficult to prevent because the details of each crisis are different, and the true causes often only become clear after the event. The underlying systemic risk is hard to predict because it involves the complex interactions of many individual actions across different agents in the system.

How can we mitigate systemic risk in financial markets?

Systemic risk can be mitigated by identifying and monitoring the hidden risks in the financial system. Policymakers and regulators can work to formulate strategies that prevent harmful collective behavior, much like engineers might anticipate how people will behave on a bridge and design accordingly.