China News Service, Beijing, Nov. 11 (Xinhua) -- How to prevent and respond to global financial risks?

——Interview with Jon Danielson, Professor of Finance and Director of the Centre for Systemic Risk at the London School of Economics and Political Science

Author: Wang Enbo, Yin Qianyun

At the beginning of this year, the banking industry in Europe and the United States "exploded" one after another, once again arousing people's worries and fears about financial risks. Although this incident has not spread to the world, at a time full of uncertainty, financial risks seem to have become a "sword of Damocles" hanging over the head of the world economy, which may fall at any time.

Why do financial risks occur? What should we do and what should not be done? What role does China play in preventing and dealing with global financial risks? Jon Danielson, professor of finance at the London School of Economics and Political Science and director of the Center for Systemic Risk Research, recently gave an exclusive interview to China News Service's "East-West Question" on the above issues.

The transcript of the interview is summarized below:

China News Service: People are so afraid and vigilant about financial risks, why do they still happen again and again? Are there common reasons behind historical global financial risks?

Jon Danielson: The essence of financial risk is simple, and it's very similar to each other. Financial risks usually occur because banks borrow large amounts of money to lend to enterprises. This looks good at first, because money brings economic activity and helps the economy grow rapidly, but when the risk occurs, it turns out that it is just an illusion. The longer the bubble accumulates, the deeper the economic collapse. If it takes too long, the collapse can turn into a crisis.

The process is well understood, and questions naturally arise as to why financial risks are allowed to occur. I think there are three related reasons.

First, it is never clear whether the harbingers of risk will actually lead to a crisis, and it is difficult to distinguish whether economic growth is based on solid fundamentals or simply due to bubbles, which can only be known after the fact. This also affects the second reason, which is that no one wants to believe that risks will happen. Those who warn about excesses tend to be blamed, and it's human nature because we prefer to believe that things will end well. At the same time, due to the high cost of risk prevention, people tend to do nothing until it's too late. Finally, most policymakers in Europe and the United States may have experienced only one crisis in their careers, so they have little experience dealing with risks and hope that they will not happen when they govern. Their lack of experience, combined with a distrust of experts with first-hand experience in dealing with risk, leads to wishful thinking, negligence and overreaction to risk.

Data map: 100 euro and 200 euro banknotes

China News Service: When talking about the banking crisis in Europe and the United States at the beginning of the year, you said that "regulators are making a big mistake". Why?

Jon Danielson: There's a synthetic fallacy in financial regulation: if every financial institution is allowed to exercise caution (well-behaved, rule-abiding, strong), then the whole system is safe. This is not right. Because if everybody is cautious, then in the event of a severe shock, which always happens, no one will be able to absorb the shock by buying high-risk assets. Instead, they will sell risky assets, which is a wise move for prudent financial institutions, but the consequence is to make the crisis worse, as this causes prices to fall and creates a tendency to spread to large amounts of assets.

In the wake of the 2008 global financial crisis, regulators tended to apply the same rules to all financial institutions, making them increasingly similar and behaving more and more convergently, which amplified bubbles on the upswing and crises on the downturn. What we need is for some institutions to buy and others to sell, so that buying and selling can change from synchronous behavior to "random noise".

The lesson for all regulators, including China, is that the principle of diversity should be embraced and different types of financial institutions should be actively encouraged, so that they will react differently to shocks and will not create very large economic bubbles and collapses.

Cover of Jon Danielson's The Illusion of Control: Exploring the Root Causes of the Financial Crisis and Managing Them. Photo courtesy of the interviewee

China News Service: In your book The Illusion of Control: Exploring the Root Causes of the Financial Crisis and Managing the Solution, you have repeatedly emphasized that the real danger is endogenous risk. How can this endogenous risk be managed?

Jon Danielson: A few years ago, my colleagues and I divided risk into two categories: exogenous risk and endogenous risk. Exogenous risk refers to events that come from outside the system, such as an asteroid that caused the extinction of the dinosaurs 6500 million years ago. Endogenous risk arises from the interaction of the people and institutions that make up the financial system within the system. Usually, the risk measured by the risk measurement tool is exogenous. The problem, however, is that large shocks are often backed by interactions between institutions in the financial system, which form vicious feedbacks to amplify shocks, or benign feedbacks to dampen shocks. It is this feedback that leads to endogenous risks.

On March 2023, 3, reporters interviewed in front of the headquarters of Silicon Valley Bank in Santa Clara, California, USA. On the same day, the Federal Deposit Insurance Corporation (FDIC) said that Silicon Valley Bank had been shut down by California regulators due to insolvency, and the company took over. Photo by Liu Guanguan

The lesson to be learned from endogenous risk is that the most important risks are hidden until it's too late. The reason for this is that visible risks are difficult to ignore and easy to solve, and can be referred to as "known unknown risks". The most dangerous risk is the "unknown unknown risk" – not knowing that it exists until it is too late. The subprime mortgage in 2008 was an example of this, and we knew it existed, but we didn't know what the system was going to do with them, and that's where the crisis came in. Endogenous risk is "unknown unknown risk".

For two reasons, authorities should not focus all their efforts on controlling the risks they can see. On the one hand, this creates the illusion that everything is under control, and on the other hand, it allows the unstable forces to grow uncontrollably. Instead, authorities should recognize that things never thought possible and be prepared to respond when they happen. In other words, don't just focus on a single shock, but look at the key factors behind the instability, which can manifest as many different shocks. Focus on fundamentals.

China News Service: US Securities and Exchange Commission Chairman Gary Gensler has warned that artificial intelligence will be at the center of the next financial crisis. Do you agree with this?

Jon Danielson: AI is likely to play a big role in the next crisis, and one way they can play a negative role is by making the financial system more pro-cyclical in its regulation and functioning. That is, to make them all take similar actions, thereby amplifying economic booms and busts. The problem is that AI can only study what is in its training set, and because crises are so unique and rarely occur, information to identify and respond to crises is unlikely to appear in the AI's training set. This is an area where humans have an advantage because humans have a lot of background information in ethics, history, politics, psychology, etc., which helps them reason about things they have never seen before. In addition, in a crisis, humans bring multiple individuals together, and this group can make better decisions, which is not currently possible with artificial intelligence.

A wise man once said that it is difficult to predict, especially the future. I don't know when the next crisis will happen, I just know that it will happen.

On September 2023, 9, the 7 China International Digital Economy Expo was held in Shijiazhuang, Hebei Province. Intelligent robots interact with visitors. Photo by Chinanews reporter Zhai Yujia

China News Service: What role does China play in preventing and responding to global financial risks?

Jon Danielson: The lesson of the past is that the best way to address global financial risks is to work together to contain them. One of the main causes of the greatest economic and financial crisis in human history, the Great Depression of 1929-1933, was the refusal of the major economic powers of the time to cooperate and focus only on their own narrow national interests. The problem is that the forces of instability are not national, but global. Thus, this narrow-mindedness provides "oxygen" to the forces of instability.

China has an active role to play in this regard. China is not only a large economy and a contributor to global mobility, but also emphasizes the development of friendly relations and cooperation to solve problems. China can use its vast resources and expertise to contain the build-up of instability and crises, and such efforts are likely to play an important role in minimizing the damage of the next crisis. (ENDS)

Interviewee Profile:

Jon Danielson is Professor of Finance and Director of the Centre for Systemic Risk Research at the London School of Economics and Political Science. He is the author of The Illusion of Control: Exploring the Root Causes of Financial Crises and Managing Themes, Financial Risk Forecasting, and The Global Financial System: Stability and Risk.