Financial Pollution: Systemic Risk and Market Stability

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.

Keywords: systemic risk, basel, financial stability, subprime

Accepted Paper Series