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The Feasibility of Systemic Risk Measurement: Written Testimony for the House Financial Services Committee Hearing on Systemic Risk Regulation


Andrew W. Lo


Massachusetts Institute of Technology (MIT) - Sloan School of Management; Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL); National Bureau of Economic Research (NBER)

October 19, 2009


Abstract:     
This document is the written testimony submitted to the House Financial Services Committee for its hearing on systemic risk regulation, held October 29, 2009, and is not a formal academic research paper, but is intended for a broader audience of policymakers and regulators. Academic readers may be alarmed by the lack of comprehensive citations and literature review, the imprecise and qualitative nature of certain arguments, and the abundance of illustrative examples, analogies, and metaphors. Accordingly, such readers are hereby forewarned - this paper is not research, but is instead a summary of the policy implications that I have drawn from my interpretation of that research. This testimony focuses on three themes:

1. Establishing the means to measure and monitor systemic risk on an ongoing basis is the single-highest priority for financial regulatory reform. In much the same way that manufacturing companies did not consider their impact on the environment prior to pollution regulation, we cannot fault financial institutions for ignoring the systemic implications of their risk-taking in the absence of comprehensive risk regulation. Unless we are able to measure systemic risk objectively, quantitatively, and regularly, it is impossible to determine the appropriate trade-off between such risk and its rewards and, from a policy and social-welfare perspective, how best to contain it.

2. Systemic risk measurement and regulation will likely require new legislation compelling systemically important entities to provide more transparency on a confidential basis to regulators, e.g., information regarding their assets, liabilities, holdings, leverage, collateral, liquidity, counterparties, and aggregate exposures to key financial variables and other risks. These requirements are much less intrusive than position transparency - which is both impractical and unnecessary for purposes of systemic risk regulation - and should already be available from any systemically important entity’s enterprise risk management system. The infrastructure required to collect, clean, analyze, organize, and store this data in a secure and robust fashion will be substantial, but this is true for any worthwhile national-level data-rich undertaking such as the Bureau of Economic Analysis, the Bureau of Labor Statistics, and the National Weather Service. Given the complexity and importance of the financial system to real economic growth - and the recessionary impact that systemic events can have on the real economy - measuring systemic risk is arguably as vital to our national interest as measuring economic productivity and weather patterns. This data-collection effort can be expedited by leveraging existing organizations and data sources including the CFTC, DTCC, Federal Reserve, FDIC, FINRA, NFA, OCC, OTS, SEC, and the credit bureaus and credit-rating agencies.

3. Because systemic risk cuts across multiple regulatory bodies that do not necessarily share the same objectives and constraints, it may be more efficient to create an independent and agency patterned after the National Transportation Safety Board (NTSB), solely devoted to measuring, tracking, and investigating systemic risk events in support of - not in competition with - all regulatory agencies. In addition to managing the data and research infrastructure described above, this agency would also be staffed by full-time and “virtual” teams of expert and experienced forensic accountants, lawyers, economists, and financial engineers who sift through the wreckage of every major financial blow-up, collect the “black boxes,” and produce publicly available reports with their findings and recommendations. Like the NTSB, this agency would assist the appropriate regulators by establishing regular lines of communication with the media as financial crises unfold to manage the flow of information and reduce the likelihood of panic, which is one of the main catalysts of crisis and much easier to prevent than they are to extinguish once ignited.

Number of Pages in PDF File: 11

Keywords: Systemic Risk, Financial Crises, Regulation

JEL Classification: G12, G14, G38, M41, M44, M49

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Date posted: November 1, 2009 ; Last revised: November 16, 2009

Suggested Citation

Lo, Andrew W., The Feasibility of Systemic Risk Measurement: Written Testimony for the House Financial Services Committee Hearing on Systemic Risk Regulation (October 19, 2009). Available at SSRN: http://ssrn.com/abstract=1497682 or http://dx.doi.org/10.2139/ssrn.1497682

Contact Information

Andrew W. Lo (Contact Author)
Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )
100 Main Street
E62-618
Cambridge, MA 02142
United States
617-253-0920 (Phone)
781 891-9783 (Fax)
HOME PAGE: http://web.mit.edu/alo/www
Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL)
Stata Center
Cambridge, MA 02142
United States
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
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