BOX 3.1

Some Possible Steps for Reducing Systemic Risk in the Financial Sector

  • Break up banks and broker/dealers that are “too big to fail.”

  • Create exchanges for credit default swaps and other large over-the-counter contracts.

  • Create an equivalent of the National Transportation Safety Board or National Weather Service for analyzing blowups and monitoring risks.

  • Require confidential disclosure regarding “network” exposures.

  • Implement countercyclical leverage constraints for bank-like entities.

  • Enforce “suitability” requirements for mortgage-broker advice.

  • Require certification for management and boards of complex financial institutions.

  • Impose more mark-to-market accounting and risk controls.

  • Impose capital adequacy requirements for all bank-like entities.

  • Create a new discipline of “risk accounting.”

  • Impose a small derivatives tax to fund financial engineering programs.

  • Revise laws to allow “pre-packaged” bankruptcies for finance companies.

  • Change corporate governance structure (compensation, role of the Chief Risk Officer, etc.).

  • Teach economics, finance, and risk management in high school.

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

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