Global Governance of Financial Systems: the International Regulation of Systemic Risk.

• Author: Banaei, B. Salman
• Position: Book review

KERN ALEXANDER, RAHUL DHUMALE, & JOHN EATWELL, GLOBAL GOVERNANCE OF FINANCIAL SYSTEMS: THE INTERNATIONAL REGULATION OF SYSTEMIC RISK, (Oxford Univ. Press 2006).

1. INTRODUCTION

   Systemic risk may be the "scariest" term in a central banker's vocabulary. (2) What is systemic risk? Consider the returns on a single investment, the actual return on an investment has two components: expected return plus (or minus) an unexpected return or risk return. (3) This risk return may be broken down into two categories: unsystemic and systemic. (4) Unsystemic risk is sometimes called idiosyncratic risk; it is the kind of risk that is specific to an asset. (5) This kind of risk is diversifiable because variance in asset returns tend to be reduced in a portfolio with an increasing number of different assets. (6) In contrast, systemic or market risk is non-diversifiable. (7) An increase in adverse systemic risk affects the returns on all assets sensitive to systemic risk in the globalized economy. (8) The term "systemic risk" is used in Global Governance of Financial Systems to denote a specific kind of systemic risk "arising from the mispricing of risk in financial markets, which often means that risk is underpriced in relation to its cost and that the underpricing of risk results in too much of it being created in financial markets." (9)

   In Global Governance of Financial Systems: the International Regulation of Systematic Risk, authors Kern Alexander (a lawyer and economist), Rahul Dhumale and John Eatwell (economists) (the Authors), argue three principal points: (1) current international and domestic efforts to contain the generation of systemic risk in financial systems are inadequate; (2) this inadequacy increases systemic risk; and (3) an international regulatory response is required. (10) This book note considers the first two arguments and related points in section II and the latter in III.

2. THE FAILURE OF REGULATORS TO PREVENT THE CREATION OF SYSTEMIC RISK

   Systemic risk is "created by individual financial institutions [and] the aggregate amount of risk created by all financial institutions in global financial markets." (11) As firms enter into risky investments (12), the aggregate of these risks accumulates, becoming a "negative externality that imposes costs on society at large because [these] firms fail to price into their speculative activities the full costs associated with their risky behavior." (13) Moreover, "adequate regulation [to prevent systemic risk] at the international level has not accompanied" the globalization of financial services and capital flows. (14)

   Adequate regulation could have prevented many recent examples of systemic risk causing events that followed from a failure of the current regulatory regime. Two specific examples may be posited as illustrations of the Authors' thesis: one considered by the Authors, the Asian Financial Crisis of the late 1990s and the other a more recent event, the United States Subprime Mortgage Crisis of 2007. Both of these display at least three common themes associated with a failure to regulate the generation of systemic risk in financial systems. First, there was an "underpricing of risk" by lenders and an absence of effective regulation to compel the pricing of risk associated with their lending practices. (15) Second, there were failures in the banking sector once these risks were realized. (16) Third, in at least some instances, there was some degree of expectation on the part of the lenders that the government would intervene if the debtors defaulted. (17) These shared common characteristics preceded a common result: fear of a broader and international economic downturn, with either "systemic risk" (18) (United States) or "contagion" (19) (Asia) being the associated buzzword.

   These domestic financial crises soon become global financial crises given the interconnectedness of financial markets. The globalization of financial systems has "made financial institutions more interdependent and thus more exposed to systemic risk that can arise from bank failures and to volatility in cash flows." (20) This globalization of systemic risk is especially pronounced in some sectors, most importantly, in the banking industry:" (21)

   The Authors point out that the Asian financial crisis of the late 1990s would have been avoided if the regulators in the affected nations had planned their liberalization programs with greater foresight. (22) Specifically, regulators should have implemented "prudential policies" that would have established "better risk management measures at the microeconomic level." (23) The inexperienced Asian banks lacked such effective policies and the "absence of adequate internal controls" on risk taking further increased risk-taking by these banks, leading over time to a "buildup of nonperforming loans." (24) These banks' risky investments adversely impacted international financial systems and amounted to the externalization of the full social cost of these risky investments onto the broader national and international economy. (25)

   Government intervention after a financial crisis in contrast to a prudential regulatory standards intended to prevent a financial crisis, may serve to increase the moral hazard problem. (26) For example, in the 1990s some Asian governments prescribed lending to specific non-performing market sectors. (27) Under the guidance of these government directives, the foreign depositors assumed that the same government institutions would protect the banks' holdings in these market sectors in the event of failure. (28) Not only do such firms undervalue risk, but the moral hazard created by the perception that the government would bail them out in the event of a market failure further increases the underpricing of risk by banks and thus the degree of systemic risk borne by the international economy. (29)

   The Authors argue that the current international regulatory framework for "banking supervision" is "especially" flawed. (30) The Basel Committee on Banking Regulation and Supervisory Practices (Basel Committee) "exercises either direct or indirect influence over the development of banking law and regulation for most countries." (31) Its most recent set of proposals, known as "Basel II," the Basel Committee intended to make the "regulatory capital (32) held by banks more sensitive to [] economic risks." (33) But despite Basel II's superficial similarity with the Authors' concern: the lack of an effective international regulatory framework for banking, Basel II is a fundamentally flawed attempt to limit systemic risk. More specifically, the Authors argue that Basel II is flawed on institutional and substantive grounds.

   First, the Basel Committee that proposed Basel II has several critical institutional flaws. Chief among these flaws is the Basel Committee's imbalanced decision-making structure. For example, "the Basel Committee is...