Is Financial Regulation Appropriately Dealing with Systemic Risk? Are We Really Fixing Existing Problems or Creating New Ones?

5 Pages Posted: 20 Jan 2014

Date Written: January 18, 2014

Abstract

What is the purpose of financial sector regulation? What problem are we trying to solve? We are not (or should not be) trying to eliminate risk from the market. There is an "optimal level of risk," and surely it is not zero. That means that there could exist inefficiently high levels of risk, but also inefficiently low levels.

Instead, we are trying to eliminate what might be called "excessive risk." But what makes risk "excessive?" To an economist, that can only mean risk which is priced too low, perhaps even not priced at all. But that is another way of saying risk which has not been fully internalized in the market, which is another way of describing an externality. In this article I summarize important shortfalls of current regulatory requirements, namely stress testing, to deal with the actual problem.

I argue that the risk to fix the problem of "excessive risk" by the banks is to directly look into the banks’ liabilities that are prone to a bank run and regulate these instead. It is simpler, straight to the core of the problem, significantly less costly to implement and less costly in terms of negative effects that excessive and mis-targeted regulation can have in terms of economic growth, than the approach actually adopted.

There were many components to the 2007-2009, which did create a perfect financial storm. But at the end of the day, it was fundamentally a problem of too much leverage on very short term debt. This fact was the trigger of the run and I believe also a key driver of contagion throughout the financial sector. Therefore, avoiding excessive risk will require that financial institutions taking deposits, borrowing overnight and issuing fixed-value money-market shares or any other type of asset that can cause a bank run then it will have to back up 100% of its liabilities with short term treasuries or reserves at the Fed.

Keywords: Basel requirements, Stress Testing, Financial Regulation, Bank Run

JEL Classification: E44, E58, G21, G28

Suggested Citation

Abrantes-Metz, Rosa M., Is Financial Regulation Appropriately Dealing with Systemic Risk? Are We Really Fixing Existing Problems or Creating New Ones? (January 18, 2014). Available at SSRN: https://ssrn.com/abstract=2381180 or http://dx.doi.org/10.2139/ssrn.2381180

Rosa M. Abrantes-Metz (Contact Author)

Berkeley Research Group, LLC ( email )

Miami, FL
United States

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