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The Systemic Risk Industry

posted by Adam Levitin

There seems to be a cottage industry now in proposals to solve and/or mitigate systemic risk. I'm myself somewhat of a guilty party. The producers here are law profs and economists (and probably some other disciplines as well). These proposals fall into three buckets. One focuses on executive compensation as the key area for reform, a second on activity and/or size limitations, and the third on changing banks' capital structures. Strangely there seems to be little integration of these three approaches, although they would seem to be complements, rather than alternatives. But we scholars tend to see every problem as a nail for our particular hammer. 

It'll be interesting to see if this industry has a half-life longer than a couple of years; I suspect not, as many of the producers in the industry are not particularly interested in financial institutions per se and are likely to migrate to the next hot application of their tool box. Among existing proposals, the most intellectual activity has focused on capital structures as key. We've seen myraid co-co bond proposals, living wills, holding company structures, alternative capital risk-weighting, leverage limits, liquidity requirements, expanded shareholder liability, and all sorts of other variations on contingent capital. (I'm pointedly not linking any of these because my point isn't to pick on any single proposal, but to note a phenomenon.)  Some of these ideas are quite creative; some reinvent the wheel (it's astonishing how many proposals are blissfully unaware that similar devices have been tried and rejected by the market in US banking history).  Some are realistic that they can at best mitigate risk; others seem to truly believe that they will make the world safe for banking and eliminate risk.  

I'm rather conflicted regarding how to view this industry. On the one hand, I'm thrilled to see this level of scholarly attention to financial regulatory issues. Would that had been the case pre-crisis. On the other hand, I get the eerie sense from reading some of these proposals that I'm witnessing a redux of structured finance, in which a lot of excellent brain power was spent on trying to develop capital structures that eliminated risk, only to find out that it had been shifted and concentrated, rather than removed. (This might be because of the prominence of co-co bond proposals, which, like securitization, are automated bankruptcy systems.) 

I've argued elsewhere that at best we can reduce risk--akin to building higher levees or flood walls--but that doing so has its own costs.  The key point is that we cannot eliminate it from the system and need to learn to live with it and allocate losses more efficiently, fairly, and transparently ex-post.  Even this, I'm not sure will hold up. Credit Slips' Own Anna Gelpern has wisely pointed out that rules are inevitably tossed overboard during financial crises as soon as they become inconvenient. I have to think that this would apply both to capital structure rules (would co-cos really convert if it affected other financial institutions' holdings?) and to ex-post loss allocation rules (again, co-cos being in effect an automated loss allocation). I hate to take such a nihilistic position, but I think we risk deluding ourselves if we think we can seriously contain, much less eliminate risk by solely by adopting new capital structures.


It is not just the academics that are enthused about cocos and various other weird and wonderful proposals. I would be very interested to see some more discussion about the Financial Stability Board's proposals on resolution frameworks.

Best way to reduce risk is to reduce the complexity of the system. That means limiting financial institutions to very narrow missions, and strict limits on the nature of financial instruments to very narrow vanilla ones.

Of course, that would eliminate much rent-collection in the financial sector, so it won't happen.

Simplification and transparency are the only real ways to reduce risk.

Almost all risk management systems and techniques merely shift risk, split risk, hide risk, or provide the added-value service of convincing people that risk has been eliminated (when it hasn't).

The few that are left (i.e., diversification) are less valuable as the systems become more complex because really these are about disentangling risk and complexity works counter to that, aligning risk across areas and coupling things together.

Really this is the lesson of the past 4 years!

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