Methods of Assessing and Managing Systemic Risk
How should governments handle large and complex financial institutions that are “too big to fail” and “too connected to fail”? The current crisis has brought that question to the forefront. Regulators need to address the too big to fail problem, as implicit guarantees raise the likelihood of crisis. Some have suggested progressive capital requirements, and many endorse macro-prudential regulatory approaches. Many, most prominently Fed Chairman Ben Bernanke (2009), now say that adequate financial regulation of very large financial institutions is crucial to managing systemic risk.
Financial globalisation has proved to be a double-edged sword in this respect. While the growing complexity and globalisation of financial services can contribute to economic growth by smoothing credit allocation and risk diversification, they may also exacerbate the too-connected-to-fail problem. For instance, greater connectedness can lead to situations where an institution’s miscalculations of its risks lead to its demise, spawning a large number of failures of financial institutions, liquidity squeezes, and even severe capital losses in the financial system. Indeed, the ongoing crisis has shown how financial innovations have enabled risk transfers that were not fully recognised by financial regulators or by institutions themselves.
Because governments will likely intervene to keep afloat institutions considered too connected to fail, those institutions enjoy an implicit safety net. But that encourages investors and managers of other institutions to also take excessive risks.
Some policymakers (e.g., Stern and Feldman 2004) have long recognised this problem and have called for “macro-prudential” oversight and regulation focused on systemic risks, not just individual institutions. However, it is easy to ignore such admonitions when times are good because the probability of an extreme or tail event may appear remote—a phenomenon dubbed “disaster myopia.” Moreover, it is difficult
Financial globalisation has proved to be a double-edged sword in this respect. While the growing complexity and globalisation of financial services can contribute to economic growth by smoothing credit allocation and risk diversification, they may also exacerbate the too-connected-to-fail problem. For instance, greater connectedness can lead to situations where an institution’s miscalculations of its risks lead to its demise, spawning a large number of failures of financial institutions, liquidity squeezes, and even severe capital losses in the financial system. Indeed, the ongoing crisis has shown how financial innovations have enabled risk transfers that were not fully recognised by financial regulators or by institutions themselves.
Because governments will likely intervene to keep afloat institutions considered too connected to fail, those institutions enjoy an implicit safety net. But that encourages investors and managers of other institutions to also take excessive risks.
Some policymakers (e.g., Stern and Feldman 2004) have long recognised this problem and have called for “macro-prudential” oversight and regulation focused on systemic risks, not just individual institutions. However, it is easy to ignore such admonitions when times are good because the probability of an extreme or tail event may appear remote—a phenomenon dubbed “disaster myopia.” Moreover, it is difficult