Endogenous risk is the risk that markets may not behave as they normally do because of a change in behavior of market participants themselves. This is in contrast to exogenous risk - that is any risk generated outside of the financial system, like an earthquake. Either may impact a stock or the market, but endogenous risk is much more far-reaching.
Jon Danielsson and Hyun Song Shin from the London School of Economics use this analogy: They recount how London's Millennium Bridge over the Thames River was designed by engineers to hold the weight of numerous pedestrians, so no problems were expected with a large crowd on the bridge on dedication day in 2000.
Once the crowd gathered, however, the bridge was hit by strong gusts of wind and began to wobble. The wobbling persisted, as people on the bridge adjusted to the gusts by changing their stances at the same time. The engineers had not planned for a situation in which everyone behaved in the same way at the same time; they had assumed that whoever was on the bridge at any given time would be moving randomly relative to one another. (The new bridge was promptly closed to allow for modifications.)
A model of random movements is analogous to the buying and selling by market participants under typical conditions. But what happens when market participants all start behaving the same way, and all of them want to sell at the same time? This can lead to fear and panic, and rapidly declining asset prices.
The markets have experienced three events representing endogenous risk recently: the 1987 stock market crash, the 1998 Long-Term Capital Management bailout and the 2008 financial crisis. In all three events, a ripple effect went through the markets, causing waves of selling and plunging prices. Much of the selling was not based upon exogenous fundamentals, but was endogenous in nature - and the fact that we have seen one per decade should be cause for concern.
What are the causes of endogenous risk?
It seems clear that the financial climate has become more conducive to endogenous events, and there are several factors pointing toward the likelihood of further events:
* The emergence of a new "financialized" capitalism.
* The rise of speculation and decline of investing.
* The increase in derivatives and use of leverage.
* Shadow banking and a lack of transparency.
* The problem of too big to fail.
A major shift occurred in the U.S. after the presidential election of 1980: the beginning of financialization. This term is used to describe the separation of financial wealth from real wealth or from the production of goods and services. Essentially, through risky innovations, the financial system, made up of banks and investors, was able to create artificial wealth that enabled those involved to capture an increased share of real wealth, and this wealth was concentrated in the richest 1% or 2% of society. According to research by economist Luiz Carlos Bresser-Pereira published by Bard College, the richest 1% controlled 23% of total disposable income in 1930. In 1980, the share had fallen to just 9%, but by 2007 it had gone back up to 23%.
In recent years, even though the financial sector contributed just 20% to GDP, it reaped 40% of corporate profits. Financial engineering aimed at making money, as opposed to creating something of value, has become commonplace, and this contributes to the instability of the financial system, thus increasing endogenous risk.
It can be argued that portfolio managers and financial intermediaries are taking too much of the returns, even though it is the investors - the "owners" - who are taking the risk by providing the capital. Managers' capitalism means that corporations are being run primarily to benefit managers and not shareholders. According to the author William Pfaff, a "pathological mutation" occurred late in the 20th century, and the classic system of trying to maximize return on capital is broken. The markets have so diffused ownership "that no responsible owner exists." An unattributed quotation cited by John Bogle, founder and retired CEO of Vanguard, sums up what happens when managers' capitalism takes over: "When we have strong managers, weak directors and passive owners, don't be surprised when the looting begins."
At the end of the 20th century, the wealthiest 1% of Americans owned about 40% of the nation's wealth (which is measured differently from disposable income), the highest share since the age of the robber barons at the turn of the previous century, when it was about 45%, according to Bogle. He warns that "a society that tolerates such differences in income and wealth is a society that faces long-term disruption."