The loss announced by JPMorgan Chase last week raises many interesting questions, one being the distinction between idiosyncratic and systemic risk. The distinction between idiosyncratic risk versus systemic risk (and idiosyncratic vs. system events) is vitally important because the sources of and the responses to the two are quite different. Unfortunately the distinction is often ignored, particularly in popular and political discussions. Sometimes it seems people intentionally confuse them.
Quoting from chapter 1 of my recent book:
Idiosyncratic risk is the risk that is specific to a particular firm, and systemic risk is widespread across the financial system. The distinction between the two is sometimes hazy but very important. Barings Bank’s 1995 failure was specific to Barings (although its 1890 failure was related to a more general crisis involving Argentine bonds). In contrast, the failure of Lehman Brothers and AIG in 2008 was related to a systemic crisis in the housing market and wider credit markets.
The distinction between idiosyncratic and systemic risk is important for two reasons. First, the sources of idiosyncratic and systemic risk are different. Idiosyncratic risk arises from within a firm and is generally under the control of the firm and its managers. Systemic risk is shared across firms and is often the result of misplaced government intervention, inappropriate economic policies, or exogenous events, such as natural disasters. As a consequence, the response to the two sources of risk will be quite different. Managers within a firm can usually control and manage idiosyncratic risk, but they often cannot control systemic risk. More importantly, firms generally take the macroeconomic environment as given and adapt to it rather than work to alter the systemic risk environment.
The second reason the distinction is important is that the consequences are quite different. A firm-specific risk disaster is serious for the firm and individuals involved, but the repercussions are generally limited to the firm’s owners, debtors, and customers. A systemic risk management disaster, however, often has serious implications for the macroeconomy and larger society. Consider the Great Depression of the 1930s, the developing countries’ debt crisis of the late 1970s and 1980s, the U.S. savings and loan crisis of the 1980s, the Japanese crisis post-1990, the Russian default of 1998, the various Asian crises of the late 1990s, and the worldwide crisis of 2008, to mention only a few. These events all involved systemic risk and risk management failures, and all had huge costs in the form of direct (bailout) and indirect (lost output) costs.
It is important to remember the distinction between idiosyncratic and systemic risk because in the aftermath of a systemic crisis, the two often become conflated in discussions of the crisis. Better idiosyncratic (individual firm) risk management cannot substitute for adequate systemic (macroeconomic and policy) risk management. Failures of risk management are often held up as the primary driver of systemic failure. Although it is correct that better idiosyncratic risk management can mitigate the impact of systemic risk, it cannot substitute for appropriate macroeconomic policy. Politicians—indeed, all of us participating in the political process—must take responsibility for setting the policies that determine the incentives, rewards, and costs that shape systemic risk.
This is from chapter 1 of
Quantitative Risk Management published by Wiley (also available in the CFA monograph
A Practical Guide to Risk Management, available for free download as .pdf, EPUB, iBookstore, or as Kindle from Amazon