Paper on Systemic Risk

Here‘s a paper on “Containing Systemic Risk” which I submitted to the European Parliament’s Monetary and Economic Affairs Committee in relation to its Monetary Dialogue with ECB President Trichet.

I’m one of a panel of “experts” that briefs the committee. Here‘s a link to the page that contains all the expert papers for this year. Click on 7.12.09 and you’ll see papers by other economists on the topic of systemic risk as well as some interesting papers on the Monetary Exit Strategies.

11 replies on “Paper on Systemic Risk”

great paper. I do think that some things could be emphasised a little more, pricing risk more appropriately is a key element, but perhaps more importantly is the entrance of non-bank credit distribution and the originate to distribute model it capitalised on.

The banks using the repo market effectively shut down overnight when the confidence in the collateral they put forward for repurchase came into doubt, bear stearns is a great example of that. perhaps volcker has the right idea in only offering guarantees and bailouts to commercial banks and letting investment banks hang. to be fair the overnight market has a place, but those who finance off it exclusively are a risk and if they can do it without facing the regulatory regime which is the basis of the offer of protection then it is a bigger risk.

dynamic capital requirements with a multiplier built into the required increase depending on credit expansion would help, that means that the quicker the expansion the more you have to put away to stay within parameters.

a broad powered single regulator per country with strong international ties would also do some good, in the US there are so many regulatory turf wars that it seems one dept. hides info from another lest they get the upper hand on any situation.

securitisation is a good thing, just not the type we have seen leading up to the crisis, perhaps a mandatory remaining liability whether real or implied would encourage banks to keep relevant capital even if the risk is moved off the balance sheet.

if you ever happen to model risk please let me know, it’ll be my treat at the roulette tables!

anyway, the paper was a great read.


This is an excellent paper and I’m sure the ECON committee will read attentively.

However, there are some ancillary aspects that I think deserve attention, particularly the moral hazard arguments concerning bank bail-outs.

It seems to me that systemic risk containment measures are a non-market substitute for what is a much more natural and market-based solution – shareholders’ fear of losing their money motivating in-house vigilance and prudence. To me, the ESRB just has an impossible up-hill battle if shareholders and bank managers are allowed to walk away from this mess with their pockets stuffed full.

Of course, NAMA is a dramatic example of this, but the issue has surfaced elsewhere in Europe too.

Thanks Karl. There are lots of good ideas out there for making the system more stable. The problem will be getting them written down in concrete terms and then getting common international agreement on them, most likely in the face of a lot of opposition from financial sector interests.

@ Graham.

I agree that one way to think about this problem is to market-based solutions to make people be more prudent. But I think that can only go so far. Even without a safety net, there will always be people who make bad gambles and lose. And this is an area where there are externalities — one badly-managed bank going down has repercussions for other well-managed banks. And these repercussions often work through a complex web of interactions that the individual actors don’t see or fully understand. So, I think there’s a case here for government interventions based on externalities and traditional information.

But, yes, I agree it’s always good to go back to basic public finance and try to figure out what’s wrong with market solutions before recommending government intervention.

@karl w: where would the fun be if industry didn’t resist? lol.

tbh: we all want regulation as it increases trust and stability, but it doesn’t seem to work that way in practice, rather it interprets into non-protective additional paperwork and an asynchronous enforcement approach where the small get crushed and the big walk with impunity.

“To me, the ESRB just has an impossible up-hill battle if shareholders and bank managers are allowed to walk away from this mess with their pockets stuffed full.”

To be fair to shareholders they haven’t done too well out of this. Shares at €1.60, down over 90% (?) and not out of the woods yet even if Nama works reasonably well. Anglo shareholders lost everything (about the only ones who did)

@Either Karl
And this is a serious question. Can you give a few good examples where government regulation actually works.

Too big to fail means too big to regulate means too big altogether.

Equity funding only for “investment” bankers and unlimited liability. Lenders beware but expect bigger returns.

Clearing and retail and mortgage banking fully regulated and a size cap.

But given the reluctance to enforce laws on those who own those who rule, nothing will change. Next credit binge 40 years hence?

@ All,

Good points, and I guess I do agree there is a market failure justifying intervention here. I just feel that this justification should be invoked in every regulatory measure, the same way the EU has to demonstrate subsidiarity before legislating…

Harvard Law School – Program on Corporate Governance

The Wages of Failure: Working draft, November 22, 2009
Executive Compensation at Bear Stearns and Lehman 2000-2008

The standard narrative of the meltdown of Bear Stearns and Lehman Brothers assumes that the wealth of the top executives of these firms was largely wiped out along with their firms.
In the ongoing debate about regulatory responses to the financial crisis, commentators have used this assumed fact as a basis for dismissing both the role of compensation structures in inducing risk-taking and the potential value of reforming such structures.

This paper provides a case study of compensation at Bear Stearns and Lehman during 2000-2008 and concludes that this assumed fact is incorrect.

@Karl W
One issue I haven’t seen discussed is borrower as risk agent.

A system that caps limits on lending is still not going to be able to measure risk unless it can measure the risk of the borrowers, whether they be individuals, private companies or public companies.

For public companies, scrutiny of their published accounts might give an indication of what companies are over-leveraged. For private companies, personal guarantees are often given to sustain borrowings. And individuals just promise to pay back based on future income. Traditionally, LTV has been used to determine skin in the game, but this is clearly not enough as individuals and companies that did have LTV and maybe have LTEV ( 🙂 ) in their assets don’t have the cash flow to support their debts.

So a cash-flow basis of risk would seem to be desirable for borrowers. i.e. you can only borrow what you will be able to service. But this would mean knowing all debts that a borrower has and the servicing costs on them – overdrafts, bonds, loans, company credit card, HP agreements, mortgages etc. And you would need to accurately know what income the borrower has to service those borrowings.

Personally, I favour using revenue organisations for determining income. If you do not declare it for tax, you should not be able to get borrowings against it. In terms of debt, a register would have to be kept and, given the EU we live in, it would have to be EU wide.

It would then be possible to set a borrowing limit for individuals which they could reasonably expect to pay back. Any failure to do so would be the result of either fraud or bad luck. In the case of bad luck, the state can pick up the pieces to some degree and the lender can accept some loss. In the case of fraud, normal sanctions would apply.

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