Some Possible Steps for Reducing Systemic Risk in the Financial Sector
SOURCE: Adapted, with permission, from Andrew Lo, Massachusetts Institute of Technology, presentation at the Workshop on Technical Capabilities Necessary for Regulation of Systemic Financial Risk, Washington, D.C., November 3, 2009.
Myron Scholes of Stanford University gave a keynote presentation that discussed the costs of adjusting portfolios when conditions change. Flexible portfolios are more expensive and less profitable. One must pay for an option that gives flexibility, and the option price is high when volatility and illiquidity are high or may become high. Leverage is inherently inflexible because positions cannot easily be sold in a downturn to pay off the debt. Illiquidity also rises in a crisis. In the run-up to the current crisis, too much leverage was taken by consumers, investors, governments, corporations, and financial entities, making the system unstable.
Scholes noted that the cost of the bailout should be compared with the costs of proactive solutions such as tighter regulation. It is possible that the bailout is less expensive. Systemic financial risk regulators are essentially risk aggregators. He believes that many systemic risks can be identified by careful aggregation of firm risk measures. This must be dynamic, as the value of liquidity provision varies over time. Stable-value products are inherently unstable and might be a source of systemic risk. Debt convertible to equity when triggered by systemic events might be an important tool for increasing flexibility. Accounting must be improved to reduce the impact of false profits and short-run compensation. Overall, firms should hold bigger capital cushions. Regulation to ensure this could improve everyone’s welfare. Incentives and monitoring must work together to reduce the possibility of systemic failures.
The keynote presentation by Robert Engle of New York University discussed the financial crisis in terms of two features—the failure to assess risks adequately and the incentives to ignore