Can We Prove a Bank Guilty of Creating Systemic Risk?

That is a new paper by Jon Danielsson, Kevin R. James, Marcela Valenzuela, and Ilknur Zer, forthcoming in the JMCB, here is the abstract:

Since increasing a bank’s capital requirement to improve the stability of the financial system imposes costs upon the bank, a regulator should ideally be able to prove beyond a reasonable doubt that banks classified as systemically risky really do create systemic risk before subjecting them to this capital punishment. Evaluating the performance of two leading systemic risk models, we show that estimation error alone prevents the reliable identification of the most systemically risky banks. We conclude that it will be a considerable challenge to develop a riskometer that is both sound and reliable enough to provide an adequate foundation for macroprudential policy.

Here is their broader piece on models of systemic risk.  Paul Krugman had a good argument today in his column on this topic:

What determines whether a firm is systemically important? There aren’t any cut-and-dried rules — there can’t be, because if there were, corporate lawyers would find ways to evade them. Instead, it’s a judgment call. But financial giants that don’t like being regulated are trying to use litigation to question those judgments.

Maybe, but I’m reluctant to define “following the law” as necessarily an attempt to game the system.  Would we use that same argument to show restrictions on leverage are counterproductive?  Quantifiable laws can indeed limit financial risk and of course Dodd-Frank, and many other financial regulations, is replete with such quantifiable laws.  Why is quantification suddenly so ineffective or even counterproductive?  We don’t from Dodd-Frank advocates hear much about this possibility in other contexts.  Furthermore, cannot the discretionary judgments of the regulators be gamed, and gamed all the more so?  Especially in generations two, three, and four of this process.  Especially in a world with a revolving regulatory door.  Especially in a world where regulators are looking for cover and, in subsequent iterations, may simply fall back on numerical standards in any case?  I say when in doubt, go with the rule of law, not the rule of men.

So I’m sticking with my previous view that the MetLife decision is more good news than bad.


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