manuel sanchez : systemic risk – policy challenges remarks by mr manuel sanchez, deputy governor of the bank of mexico, at the mfi international harper lecture, milton friedman institute, mexico city, 11 may 2011. * * * it is a pleasure and an honor to participate in this panel of the mfi international harper lecture. for me, this conference is particularly relevant as the key note speaker is distinguished economist, lars peter hansen, my former professor, a member of my thesis committee and a good friend. as in the days when i took courses from lars at the university of chicago, today i have learned a lot from his interesting presentation on systemic risk. i would like to comment on some policy challenges related to systemic risk, hoping that they may complement lars ’ deep empirical insights on this issue. in my remarks, i will emphasize three points : first, that the available definitions of systemic risk are dependent on judgment in an environment of uncertainty ; second, that we need a deeper understanding of the causes of systemic risk, particularly regarding the distinction between root factors and symptoms ; and third, that policy measures should be clearly designed to mitigate the causes of systemic risk. i would like to mention that these comments are entirely my own and do not necessarily reflect those of the bank of mexico. the notion of systemic risk let me begin by recognizing that there is no widely accepted definition of systemic risk. however, any overview of research and policy reports in this area uncovers a frequently held notion of systemic risk as the possibility of a disruption affecting the normal functioning of the financial system. there are at least three noteworthy elements of this common concept. one is the reference to the financial system. this definition implies a potentially large scope, as the referred system can comprise all financial intermediaries, regulated and unregulated ; the markets of all financial assets ; the infrastructure that the financial system uses to perform its tasks, including payments and settlements ; and, the regulatory framework. the second element is the allusion to normal functioning. the activities of any well operating financial system are many, but they can be summarized as intermediating payments, converting savings into lending usually through maturity transformation, and managing risk. however, to my knowledge, there are no clear indicators of what normal functioning is meant to be, which makes this qualification subjective, as it calls for the judgment of the observer or the policy maker. for instance, do stock - market crashes or sudden and substantial currency depreciations constitute interruptions to normal functioning?

what must be the depth of these adjustments in order to consider them deviations from normality? when does a “ credit crunch ” become disruptive? unfortunately, neither economics nor experience gives an unequivocal answer to these questions. still, any answer has necessarily policy implications. the subjective characteristic of this notion does not disappear by resorting to the opposite concept of financial stability. here again, although there is no universal definition, stability is usually interpreted as a situation in which the financial system is resilient to disturbances that may threaten its normal functioning. in both concepts, sometimes disruptions are meant to be turbulences that may have a substantial negative impact on the real economy. yet, this bis central bankers ’ speeches qualification only translates the vagueness from one term to another – i. e., when is the impact substantial? – maintaining the nature of the assessment subjective. 1 the third element is the reference to a probabilistic world, as risk refers to the possibility of incurring in a negative outcome. for example, the oxford english dictionary defines risk as “ the possibility of loss, injury, or other adverse or unwelcome circumstance ; a chance or situation involving such a possibility ”. however, any risk definition assumes all possible outcomes and their associated probabilities as known. as the unprecedented nature of the recent global crisis reminded us, prior knowledge of the probability distribution of the different kinds and degrees of disruptions can easily be incomplete. hence, some potential negative events may be truly “ unknown unknowns ” and fall into the realm of uncertainly, not risk, as defined by knight. in uncertainty, not all possible outcomes and their associated probabilities are known. 2 the conclusion from this analysis is that available concepts of systemic risk are vague and too wide to be operationally useful. if any policy framework is to be designed and applied in a meaningful way to counteract systemic risk we need to narrow this concept and make it more precise. in this sense, precision implies measurability. as correctly stated by lars hansen, unless we are able to measure systemic risk objectively, quantitatively, and regularly, it is impossible to determine the appropriate trade - off between such risk and its rewards and, from a policy perspective and social welfare objective, how best to contain it. lars ’ concern regarding the challenges of monitoring these risks in terms of modeling, measurement and data accessibility is of prime relevance. 3 sources of systemic risk while the notion of systemic risk is