It is crucial to distinguish idiosyncratic risk from systemic risk. The former is related to risk that originates from or is inherent to a specific entity such as a firm, whilst the latter is risk that is exogenous to the firm. The reason why making a clear distinction between the two risks is so important is because their expected antidotes are so different. Idiosyncratic risk is normally handled by the management team of the firm and only involves outside intervention in situations of "too big to fail" where repercussions in terms of systemic risk become all too real. Systemic risk, on the other hand, is usually beyond the scope of management, it is more within the domain of policymakers.
Applying the distinction to the current Euro-zone crisis, we began with a form of risk when the peripheral members started to ring the alarm bells in the first half of 2010 that was borderline idiosyncratic but still relatively contained. This explains why the initial response to this "mini" crisis was relatively muted: the creation of a fund that would aim at bailing out heavily indebted nations that were having difficulty with their payments. The risk started to take on a more systemic form when the number of troubled countries began to increase and as it began to involve countries that had economies that were far bigger than the first wave. The EU response to this was mainly to increase the size of the "bailout" fund but not much else when what they really should have been doing was to approach the problem from a completely different angle. But herein lies the problem: the Euro-zone in its current incarnation was never designed to handle such challenges.
Applying the distinction to the current Euro-zone crisis, we began with a form of risk when the peripheral members started to ring the alarm bells in the first half of 2010 that was borderline idiosyncratic but still relatively contained. This explains why the initial response to this "mini" crisis was relatively muted: the creation of a fund that would aim at bailing out heavily indebted nations that were having difficulty with their payments. The risk started to take on a more systemic form when the number of troubled countries began to increase and as it began to involve countries that had economies that were far bigger than the first wave. The EU response to this was mainly to increase the size of the "bailout" fund but not much else when what they really should have been doing was to approach the problem from a completely different angle. But herein lies the problem: the Euro-zone in its current incarnation was never designed to handle such challenges.
It seems to me that the original architects of the Euro-zone project are now paying a heavy price for having suppressed the major risks or negative points that were outlined in the independent study on the creation of a Euro-zone that had been commissioned by the core governments of the project. As we can see from the CDS graph of Italy, it is just another example of too little, too late.
