Avoiding Eight-Alarm Fires in the Political Economy of Systemic Risk Management

75 Pages Posted: 16 Feb 2010 Last revised: 1 Dec 2013

Jeffrey N. Gordon

Columbia Law School; European Corporate Governance Institute (ECGI)

Christopher Muller

Independent

Date Written: March 26, 2010

Abstract

The inherent tensions in the financial sector mean that episodes of extreme stress are inevitable, if unpredictable. This is so even if the regulatory and supervisory regimes are in many respects effective. The capacity of government to intervene may determine whether the distress is confined to the financial sector or breaks out into the real economy. Although adequate resolution authority to address a failing financial firm is a necessary objective of the current regulatory reform, a firm-by-firm approach will be unable to address a major systemic failure such as the Crisis of 2007-08, which may require capital support of the financial sector to avoid severe economic harm. We therefore propose standby systemic emergency finding authority, triggered by agreement among Treasury, the Federal Reserve, and the FDIC. Such a fund, scaled appropriately to the size of the US economy, $1 trillion, should be funded (and partially pre-funded) by risk-adjusted assessments on all large financial firms, who benefit from systemic stability. Standby emergency authority avoids the need for high stakes legislative action mid-crisis, which can be destabilizing even if successful and catastrophic if not. The triple key‖ constraint and on-going monitoring and oversight should address concerns of legitimacy and accountability.

Keywords: Financial Crisis, Bank Regulation, Emergency Authority, Financial Innovation, Federal Reserve, Credit Default Swap, Lehman Brothers

JEL Classification: E61, G28, H81, K23, P16

Suggested Citation

Gordon, Jeffrey N. and Muller, Christopher, Avoiding Eight-Alarm Fires in the Political Economy of Systemic Risk Management (March 26, 2010). Columbia Law and Economics Research Paper No. 369; ECGI - Finance Working Paper No. 277/2010. Available at SSRN: https://ssrn.com/abstract=1553880 or http://dx.doi.org/10.2139/ssrn.1553880

Jeffrey N. Gordon (Contact Author)

Columbia Law School ( email )

435 West 116th Street
Ctr. for Law and Economic Studies
New York, NY 10027
United States
212-854-2316 (Phone)
212-854-7946 (Fax)

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

HOME PAGE: http://www.ecgi.org

Christopher Muller

Independent ( email )

New York, NY
United States

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