Risky Business: The Credit Crisis and Failure (Part I)

Arewa, Olufunmilayo B. | May 31, 2010

The credit crisis represents a watershed event for global financial markets and has been linked to significant declines in real economy performance on a level of magnitude not experienced since World War II. Recognition of the crisis in 2008 has been followed in 2009 and 2010 by a plethora of competing proposals in response to the credit crisis. The result has been a cacophony of visions, voices, and approaches. The sheer noise that has ensued threatens to drown out the fundamental core questions that should be asked about the credit crisis. Among the most important are questions about the relationships between risk, regulation, and failure. The credit crisis can be viewed as a type of financial market network failure. The credit crisis underscores the complex and linked nature of contemporary financial markets, as well as the inherent difficulties regulators and industry participants face in managing complex and interconnected risks. The credit crisis also demonstrates that neither industry participants nor regulators fully apprehended underlying financial market risks. In recent years, financial products and financial markets have become increasingly complex and global. Although public commentary and policy discussions in the credit crisis aftermath focused on the implications of financial services firms that are “too big to fail,” existing commentary devotes less attention to the network-like characteristics of financial markets and the implications of complex networks for financial markets. The impact of financial market networks is heightened by the pervasive cultures of trading and risk-taking that now characterize many market segments. The risk-taking associated with financial market trading activities is perhaps best illustrated by cases of individual traders who took on risky trading positions that significantly compromised or, in the case of Baring Brothers, destroyed the firms on whose account they trade.