1:50 AM PDT, October 5, 2009, updated at 6:46 PM PDT, October 11, 2009
In the current issue of the BIS Quarterly Review, Tarashev, Borio and Tsatsaronis define a systemic event as one generating losses sufficiently large that could disrupt the functioning of the system. The three drivers of systemic risk are (1) the individual riskiness of firms; (2) the concentration of the system in relatively large institutions; and (3) the exposure of firms to common risks or to interconnectedness of transactions. There is significant emphasis on technical research and practical policy proposals in creating a regulatory architecture for prevention of systemic risk and its control when it occurs. There are specific proposals of a consolidated supervisor of systemic risk. A risk council composed of all supervisors of financial institutions would conduct oversight by monitoring and identifying systemic risk throughout institutions supervised by the Fed, FDIC, OCC, OTS and everything under the SEC. All institutions posing systemic risk such as investment banks, insurance companies, finance companies (GMAC) and capital companies (GE) would be subject to systemic risk supervision. There are four hurdles to systemic risk architecture. First, an effective oversight council would require consolidation of all supervisors and regulators, which may be unfeasible in practice because of the division of oversight functions in Congress and agencies. Second, winding down the balance sheet of Lehman with worldwide exposures illustrates the technical challenge of creating a global regulatory model for measurement and simulation of systemic risk that could provide analysis, prediction and policy solutions. Third, the credit/dollar crisis originated in nonprime mortgages encouraged by the near zero interest rate in 2003-4, the $220 billion yearly housing subsidy and the purchase or guarantee of $1.6 trillion nonprime mortgages by Fannie and Freddie as analyzed in the previous post. Fourth, the alleged systemic event originating in Lehman and AIG has been disproved by Cochrane and Zingales who have shown that the confidence shock in the financial system originated after Lehman by the proposal of TARP as required in avoiding devastating financial crisis. The key function of transforming illiquid assets such as mortgages in immediate liquidity by means of sales and repurchase agreements was fractured by confidence uncertainty caused by policy. The systemic event originated, widened and deepened by the effects of policy impulses. Regulatory architecture of systemic risk should be based on clear analysis of the origins and propagation of the credit/dollar crisis to avoid future regulatory confidence shocks. Policy with imperfect knowledge and tools may accentuate instability and frustrate financial innovation and economic growth.
http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10