By Sell on News, a global macro analyst. Cross posted from MacroBusiness
A question that has been asked, but not nearly often enough, is why did the complex risk defrayal methods fail so completely during the global financial crisis? The GFC proved that risk measures based on INTERNAL measures, i.e. measures within the system, will fail. At the time of the GFC many participants thought they had defrayed their risk only to find out that they had not.
What is needed is a measure of risk that is EXTERNAL to the system. This is a logical necessity. The financial system works of the assumption that risk can be shifted from individual exposures. But risk cannot be eliminated, it can only be moved, something that was obvious to many outside observers but not to financial practitioners. What happens is that the risk is moved on to the system, which exposes all participants in ways they cannot anticipate. That defeats risk management. This is particularly evident with the proliferation of high frequency trading, where we are seeing stop loss orders fail because of system melt down.
An anthropologist friend, Dr Larry Cromwell, calls this vulnerability. When added to risk measures, it can give a much better chance of being able to defray risk effectively. Certainly something is needed that is outside the financial system. It is analogous to the famous incompleteness theorems of Kurt Godel , the Austrian philosopher which is stated thus:
If the system is consistent, it cannot be complete.
The consistency of the axioms cannot be proven within the system.
This should be mandatory reading for any financial analysis of risk. As Godel showed, even a basic arithmetic equation requires some external element to be validated for it to be proved. Anything else is self delusion and it was