An Information Market Proposal for Regulating Systemic Risk

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).

Keywords: Systemic risk, financial contagion, information markets, financial regulation

Accepted Paper Series