Regulating systemic risk: towards an analytical framework.

• Author: Anabtawi, Iman

The global financial crisis demonstrated the inability and unwillingness of financial market participants to safeguard the stability of the financial system. It also highlighted the enormous direct and indirect costs of addressing systemic crises after they have occurred, as opposed to attempting to prevent them from arising. Governments and international organizations are responding with measures intended to make the financial system more resilient to economic shocks, many of which will be implemented by regulatory bodies over time. These measures suffer, however, from the lack of a theoretical account of how systemic risk propagates within the financial system and why regulatory intervention is needed to disrupt it. In this Article, we address this deficiency by examining how systemic risk is transmitted. We then proceed to explain why, in the absence of regulation, market participants cannot be relied upon to disrupt or otherwise limit the transmission of systemic risk. Finally, we advance an analytical framework to inform systemic risk regulation.

INTRODUCTION I. THE ROLE OF INTRA- AND INTER-INSTITUTIONAL CORRELATIONS IN THE TRANSMISSION OF LOCALIZED ECONOMIC SHOCKS TO THE FINANCIAL SYSTEM A. The Correlations as Systemic Risk Transmission Mechanisms B. Using the Correlations to Explain Financial Crises 1. The Great Depression 2. Long-Term Capital Management 3. Enron 4. The Recent Global Financial Crisis II. CONSTRAINTS ON THE ABILITY AND WILLINGNESS OF MARKET PARTICIPANTS TO ADDRESS SYSTEMIC RISK TRANSMISSION A. Impediments to Financial Market Self-Regulation 1. Explaining Risk Transmission Through the IntraFirm Correlation Between Low-Probability Risk and Firm Integrity a. Conflicts b. Complacency c. Complexity 2. Explaining Risk Transmission Through the InterInstitutional Correlation Among Financial Institutions a. Complexity Revisited b. The Tragedy of the Commons B. Future Impediments to Financial Market Self-Regulation III. IMPLICATIONS FOR REGULATING SYSTEMIC RISK A. Managing the Correlation Between Low-Probability Risk and Institutional Integrity 1. Regulating Conflicts 2. Regulating Complacency 3. Regulating Complexity B. Managing the Correlation Among Financial Institutions 1. Regulating Complexity Revisited 2. Regulating the Financial Commons C. Addressing Systemic Crises Ex Post D. Applying the Framework to Financial Crises 1. The Great Depression 2. Long-Term Capital Management 3. Enron 4. The Recent Global Financial Crisis CONCLUSION INTRODUCTION

Governments worldwide are struggling with the challenge of regulating financial systemic risk--the risk that a localized adverse shock, such as the collapse of a firm or market, will have repercussions that negatively impact the broader economy. (1) In the United States, legislators have enacted an array of measures intended to strengthen the financial system, many of which consist of broad delegations of authority to regulators who will need to implement them in the years ahead. These measures, however, are largely a response to the recent global financial crisis. None is situated within a general theoretical framework for understanding how systemic risk is transmitted or how regulation should address it. As a result, financial regulatory reform may succeed in addressing the specific problems that led to the recent financial crisis. Because economic shocks are generally unpredictable, (2) however, the measures enacted are unlikely to be effective against future financial crises.

This Article analyzes the potential for regulation to make the financial system more resilient to the risk of collapse. We begin, in Part I, by examining how systemic risk is transmitted. We posit that two otherwise independent correlations can combine to transmit localized economic shocks into broader systemic crises. (3) The first is an intra-firm correlation between a firm's financial integrity and its exposure to the risk of low-probability adverse events that either constitute or could lead to economic shocks. (4) The second is an inter-institutional correlation among financial firms and markets (collectively, "institutions"). (5) As we illustrate using four financial crises within the past century, these two correlations have at times combined historically to potentiate the transmission of localized economic shocks throughout the financial system. (6)

After describing a transmission mechanism for systemic risk and demonstrating its operation, we examine, in Part II, whether market participants can be relied on to protect against systemic risk without regulatory intervention. We identify a series of market failures, in part caused by behavioral failures that make it unlikely that they will do so. These failures--which consist of conflicts of interest, complacency, complexity, and a type of tragedy of the commons--collectively obscure or motivate firms to ignore the impact of their risk-taking on systemic stability.

Because of these failures, regulation has an important role to play in managing systemic risk. To be effective, however, regulatory measures directed at enhancing the stability of the financial system must be designed in the context of an analytical framework that both captures the systemic transmission of economic shocks and explains the behavioral and other market failures that justify intervention. In Part III, we show that government can disrupt the transmission of systemic risk by addressing these failures. We then apply our analysis to the four financial crises discussed in Part I.

A primary lesson of the recent global financial crisis is that attempts to address systemic crises after they have occurred are enormously costly. They can also encourage moral hazard by financial firms that anticipate being rescued from public funds. Regulation can play an important role in limiting these costs. Effective systemic risk regulation should attempt to weaken correlations within the financial system that serve to transmit systemic risk. The task is urgent because increasing complexity within the financial system will make these correlations increasingly likely to arise, as well as to combine, in the future.

1. THE ROLE OF INTRA- AND INTER-INSTITUTIONAL CORRELATIONS IN THE TRANSMISSION OF LOCALIZED ECONOMIC SHOCKS TO THE FINANCIAL SYSTEM

   Four financial crises within the past century--the Great Depression, the meltdown of Long-Term Capital Management (LTCM), the collapse of Enron, and the recent global financial crisis--illustrate that two seemingly independent correlations can combine to potentiate the transmission of localized economic shocks throughout the financial system, amplifying them in the process. The first of these is a correlation between low-probability risk and firm financial integrity, and the second is a correlation among financial institutions. In Part I, we describe these two correlations and examine how they can combine. We then use the correlations to explain systemic risk transmission in the specific contexts of the foregoing crises.

   We recognize that additional financial crises have occurred over the past century and longer, and that a complete study of all such crises might indicate additional correlations within the financial system. Nonetheless, the ability of the combination of these two correlations to potentiate the transmission of economic shocks makes them worthy of study even if other correlations exist. (7)

   1. The Correlations as Systemic Risk Transmission Mechanisms

      Our starting point is the definition of systemic risk proposed by one of us in his Georgetown Law Journal article, Systemic Risk. (8) In that article, the author recognized that the term "systemic risk" has been used in various ways, sometimes inconsistently. (9) Drawing on the importance of the dynamic relationships among institutions in the financial system, he advanced the following working definition of systemic risk:

      [T]he risk that (i) an economic shock such as market or institutional failure triggers (through a panic or otherwise) either (X) the failure of a chain of markets or institutions or (Y) a chain of significant losses to financial institutions, (ii) resulting in increases in the cost of capital or decreases in its availability, often evidenced by substantial financial-market price volatility. (10) While the foregoing definition is helpful in establishing the nature and scope of the problem we are addressing, it does not identify the mechanisms by which an economic shock produces systemic consequences. By setting forth a description of the mechanisms by which shocks can travel from their points of origin to the rest of the financial system, we hope to shed light on the most promising avenues for regulatory policies directed at managing systemic risk.

      The first correlation that we identify describes the relationship between low-probability risk and firm integrity. By "low-probability," we do not mean an occurrence that is unforeseeable. Such events, referred to as "black swans" by Nassim Taleb, cannot be identified ex ante. (11) Rather, we are addressing what Taleb calls "gray swans"-events that are rare but nevertheless predictable. (12) The latter events, unlike the former, are susceptible to measurement and prediction. (13)

      Managing the risk to which a business is exposed is the domain of corporate risk managers. (14) Corporate risk managers address risk by engaging in prudent risk-taking and using financial hedging instruments as risk-management tools. In these ways, managers are able to pursue strategies for increasing firm value that would otherwise exceed the firm's tolerance for risk. In managing risk, however, we believe that managers of financial firms systematically underestimate the likelihood of encountering low-probability adverse events. In Part II.A.1, we theorize that this tendency results from managerial conflicts of interest, undue complacency when forecasting low-probability adverse events, and increased financial...