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By Jason Stipp | 06-15-2010 04:30 PM

Can You Prepare for Systemic Risk?

Morningstar markets editor Jeremy Glaser on the sources and pathways of systemic risk, and how to prepare for the unknowable.

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Jason Stipp: I am Jason Stipp for Morningstar. It's Risk Control Week on, and today we are talking to you about the concept of systemic risk. This is something that's been on a lot of investors minds since the recent downturn.

And here with me to offer some insight on what systemic risk is and what it might mean for your portfolio is Morningstar markets editor, Jeremy Glaser.

Jeremy, thanks for joining me.

Jeremy Glaser: You are welcome Jason.

Stipp: This is a concept that we have been hearing a lot about, this idea of a system and a risk from the system, but I think it's kind of squishy in some people's minds. Can you give some clarity or some structure around how to think of this notion of systemic risk?

Glaser: It absolutely is a squishy concept, unlike something like volatility, which you can go out into the market and actually measure, something like systemic risk doesn't have a really good quantitative measurement. It's an idea that we have to grapple with without putting a lot of numbers around it.

And I think the best way to think about it is, instead of a risk related to an individual company failing or individual product not succeeding, it's that the entire system is going to come down. The entire system will fail. So let's say, it's a bank that's too big to fail or in some other way that there is no way that it can continue to succeed even without it.

Stipp: And I think the recent example of how that plays out, is that a lot of things will go down at the same time. So you can't really diversify away this sort of systemic risk, and that's what we start to see in the financial crisis. And I think maybe that's a good way to frame what systemic risk might be, at least, a good recent way to frame it.

Glaser: The financial crisis was a great example. If you take a look at Lehman Brothers, on its face, it doesn't seem like it would be big enough to bring the entire world financial system and the world economy for that matter to its knees, but it was. And the reason was, it was incredibly interconnected to a lot of different institutions and it challenged investor notions of what the system should look like.

The idea that you'd be able to get this overnight financing every night without worrying about it and that bankruptcies would happen in a certain controlled way, that those notions just kind of fell apart, people started to panic.

And when they started to panic you saw other organizations and other financial firms come under extreme pressures. Either get forced into suitors' arms or to really just make it by the regulators pumping a ton of liquidity into the marketplace. And there were times that it looked really scary.

And because the financial institutions are so interconnected into this so-called real economy, you end up with businesses that need financing to get inventory and to do other things just to run their business day-to-day, couldn't get that. And then it becomes difficult for that manufacturer to work out and that hits end demand, and you see this cycle. And before you know the entire economy is in a lot of trouble, because the whole system and the way that we conceived the system, kind of fell apart at the seams.

Stipp: So what we are seeing really then is not necessarily just the financial system, because it's so systemic that even the guy that makes widgets down the street can't get that short term funding to make his payroll and suddenly his business is at risk because of this systemic problem?

Glaser: Precisely.

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