How Government Can Mitigate Systemic Risk Without Bailouts

Published August 1, 2009

For the past 50 years, Americans have invested most of their financial assets in private and public capital markets. The risks we undertake and the way we manage them determine our economic future.

While we may delegate investment activities to specialists such as banks, insurance, and other financial companies, we retain responsibility. This means systemic risk is polycentric and difficult to regulate.

Here is my definition of systemic risk: It is the risk that disturbances in one component of a system will spread to other components and affect the health of the entire system. It arises when parties on one side of an economically significant set of financial contracts unexpectedly demand payment and their counter parties cannot liquidate assets quickly enough at the right price to meet this demand.

A large and unexpected change in the demand for liquidity is itself a disturbance that creates more disturbing effects. When too many investors attempt to sell assets at the same time, supply exceeds demand, which creates downward pressure on prices. Falling prices worry other investors, and even those who do not have a need for liquidity attempt to sell in order to avoid losses, creating further pressure on prices and diminishing asset values.

A rapid and unexpected fall in value creates panic and real economic effects that can lead to large-scale insolvency from which it is difficult to recover.

Prudent Contracting, Properly Enforced

The regulatory policies that best address risk are those that require economically prudent contracting, reduce costs, and enforce just and equitable contract laws.

What can financial regulators do? In addition to developing deep expertise in the area they supervise, they can do the following:

* Collect and disseminate information about the economy, the financial system, and risk management practices so investors can make better-informed decisions;

* Monitor risk management practices and conduct periodic stress tests, focusing on activities in the up side of the business cycle, when prudence often diminishes;

* Enforce contract laws and prudential standards;

* Facilitate orderly resolution of insolvent entities;

* Co-invest in tools and infrastructure that facilitate trading, clearing, settlement, conflict resolution, monitoring, and enforcement; and

* Convene intermediaries to promote adaptive innovations in the financial system and to clear bottlenecks that inhibit coordination such as creating layered public-private financial structures to address catastrophic risks, dealing with crises, and so on.

We can do a better job of reducing systemic risk, but our solutions must be based on well-informed estimates of vulnerabilities, not ideology, partisan bickering, or mindless dependence on regulatory authorities.

Margaret M. Polski is an affiliate research fellow in the Center for the Study of Neuroeconomics at George Mason University.

For more information …

“Systemic Risk and the U.S. Financial System,” by Margaret M. Polski: