The Systemic Risk Council

I received this in an email today:

The
best approach to preventing future financial crises is through the
creation of a Systemic Risk Council —composed of at least the Fed,
Treasury, FDIC and SEC, according to William Isaac, former chairman of the Federal Deposit Insurance Corporation, and now chairman of Global Financial Services for consulting firm LECG.

To be sure, systemic risk is an important topic for regulators.  But the idea of a "systemic risk council" is much better than the idea of a Systemic Risk Council, all caps.  The more formal the institution, the greater its power to spook markets and become a source of systemic risk itself.  Let's say that an SRC were summoned into being and one day the Council warned that systemic risk was unacceptably high.  Economic activity would plummet and freeze up immediately and furthermore a liability issue could arise for any manager who did not shut down lots of plans.  The practical reality is that the Council would have to be very, very cautious in its statements and actions.  It's a bit like how the security alert these days is always on "Orange."  High enough to indicate some kind of warning and to protect the regulators from a charge of complacency, but not so high as to terrify everyone or indeed inform anyone.

I've heard some people argue that once the Council sees that systemic risk is too high, it will proceed silently and secretly, in Ninja-like fashion (my words, not theirs), to stamp it out by alerting other regulators about the problem.  I'm not convinced.

I am not arguing that we should simply stay put when it comes to financial regulation.  It would be good to limit forum-shopping, for instance, and also abolish the Office of Thrift Supervision and transfer its powers to the FDIC.  They are the group that dropped the ball on AIG, if you recall. 

The broader point is this.  Better regulation comes through many years of experience and gradual process improvements, built upon some reasonable methods for imposing regulatory accountability.  That's how the FDIC got to be good at much of what it does.  Better regulation does not come from sitting down, waving a wand, and hoping that a new name or box will address the problem you are concerned about.  Keep that in mind next time you hear that "now is the unique moment," etc.

Comments

Great post Tyler. I haven't looked at any formal measures, but the stock market's volatility is surely much much higher than it was before Bear Stearns. I think that is more due to the government's daily announcements, than to the underlying bad assets.

The best goal for systemic risk regulators would be keeping risks uncorrelated. Given the tendency for markets to synchronize expectations (and hence risks), this goal might be accomplished by limiting the percentage of business that financial institutions can do in any one market and requiring that every institutions has a slightly different bundle of percentages. It is far more difficult to synchronize expectations when everybody has a different revenue stream.

The robustness of a partially desynchronized financial industry is a value to be considered alongside rcost-efficiency.

Tyler --

Except that, at some point, you need to evaluate whether the materials you have to work with are so corrupted by politics, burdened with institutional inertia, and incapable of rising to the challenge of "gradual process improvements" and increased "regulatory accountability" that it would be better to start over.

As someone who has been under the regulatory supervision of the SEC for 20 years, I believe that institution just cannot be made functional with incremental measures. Its staff is either demoralized or incompetent, its bureaucracy is sclerotic, and the regulations it is charged with enforcing are either outmoded, ineffective, or counterproductive in many instances. I say shut it down, draw up a new blueprint, and start over.

But then again, I believe it would be better to throw away the entire federal tax code and start from scratch there, too. Go ahead, call me a dreamer. I'm used to it.

http://epicureandealmaker.blogspot.com/2009/06/these-dark-satanic-mills.html

@babar

You don't need to know how risks are correlated to know that they are correlated or to prevent them from becoming too correlated.

What we know with certainty is that leverage amplifies risk and that similar bundles of securities result in correlated risk. One way to reduced systemic risk is to limit leverage, but that raises costs without any offsetting benefits. Another way is to require comparably sized institutions to carry different bundles of risk. This also raises costs of but also has the benefit of making the system as a whole more resistan to shocks.

What we built in the '90s was a financial service industry zoo of the fattest juiciest pigs -- which made sense because everybody wants the tenderest cheapest pork. Until swine flu came along. Whoops. Maybe we should have raised some chickens and goats and cows too.

What I'm saying is that one can see with statistics whether buying and selling is getting correlated by looking at autocorrelations in price series without knowing in detail what's causing the correlation at the level of microstructure. Gaussian statistics = uncorrelated or perfectly synchronized; Levy statistics = in between. That much I think is pretty intuitive.

What I'm saying that I admit is more arguable is that we should probably try to keep things in between by building asymmetries into the risk profiles of our financial institutions with regulations. I take your point that this is difficult to do and likely to have unintended consequences. But if I have to choose between trying that and an alternative like simply raising capital requirements across the board, I know what I'd choose.

There is no "systemic risk." There, however, bona fide, complete incompetents who have hoodwinked the taxpayer with this nonsense and "too-big-to-fail." Can the systemic risk regulation. Let'em fail.

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