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Abstract:
This Article analyzes systemic risk in the financial system and shows how current regulations provide insufficient protection for our capital markets. Though the mortgage crisis and subsequent liquidity crisis currently effecting Wall Street provide the context for this analysis, this Article is not meant as a full account of these events, nor a detailed exploration of our banking regulations. Rather, this Article shows how the incentives created by our current regulatory regime lead to externalities which threaten the stability of the financial system. By focusing on the incentives guiding financial actors, this paper is able to propose a novel regulatory approach to financial regulating using mechanisms that have effectively internalized external costs in conceptually similar scenarios.

Current regulatory mechanisms aimed at producing financial stability, specifically the Basel II Capital Adequacy Framework, actually exaggerate crises by forcing firms to sell assets during liquidity shocks, compounding firms' tendencies to panic. These command and control regulations fail because they at-tempt to legislate around the problem instead of adequately addressing the inefficient incentives that influence firms and their managers. However, as will be discussed below, a market-based, cap and trade system may resolve many of these issues by directing firms towards more socially optimal investment strategies.

systemic risk, basel, financial stability, subprime

Abstract:
Legislators are calling for a “systemic risk regulator”, in part to provide an early warning of financial conditions that threaten the real economy. To succeed, however, we need a forward-looking measure of systemic risk. Even more, we need a measure that varies with “pollution” from financial transactions, not private costs and benefits on which popularly cited measures (such as the TED spread) are based. Our article thus proposes a new contract, one that derives from financial correlations that emerge from systemically consequential actions (i.e., financial transactions that affect third parties), and leverages important advantages of information markets (namely, incentives for individuals who are closest to relevant information to rationally develop and truthfully reveal expectations). We also offer a statistical back-test of our proposed contract, and find evidence that it could have anticipated important changes in systemic risk over the past ten years. Finally, we consider how this type of contract can be implemented within existing information market regulations, and how information from trading the contract can improve conventional tools of financial regulation (e.g., bank examinations, capital requirements).

Systemic risk, financial contagion, information markets, financial regulation