A proposal to prevent wholesale financial failure by Lasse H. Pedersen and Nouriel Roubini

The worst financial crisis since the Great Depression has highlighted the risks from the collapse of systemically important financial institutions. Huge bail-outs were undertaken based on a fear that the collapse of such institutions would cause havoc, with collateral damage to the real economy. Examples include Bear Stearns, Fannie, Freddie, AIG, Citi¬group, the insurance of money market funds and new US Federal Reserve programmes for banks and broker-dealers. Allowing Lehman Brothers to collapse had such severe systemic effects that the global financial system went into cardiac arrest and is still dealing with the aftermath.

We propose a way to measure and limit this systemic risk and reduce the moral hazard and the cost of bail-outs. Our proposal is to impose a new systemic capital requirement and systemic insurance programme.

The current situation leaves the system vulnerable to financial contagion when big banks (or many small ones) go bust. The root of the problem is that banks have little incentive to take into account the costs they impose on the wider economy if their failure prompts a systemic liquidity spiral. This is akin to when a company pollutes as part of its production without incurring the full costs of this pollution. To prevent this, pollution is regulated and taxed.

Unfortunately bank regulation, such as the Basel accord, ignores systemic risk since it analyses the risk of failure of each bank in isolation. It seeks to limit the probability of failure by each bank, treating isolated failures and systemic ones in the same way (and also ignoring how much a bank loses if it fails). However the move by many large banks to lever their balance sheets with similar mortgage-backed securities is more dangerous than if they had made loans to diverse borrowers.

More broadly, a systemic crisis that feeds on itself is more dangerous than the isolated failure of smaller banks. A small bank will probably be taken over with a smooth transition of operations – it does not bring down the economy.

There are two challenges associated with reducing the risk of a liquidity crisis. Systemic risk must be first measured and then managed. We propose to define a bank’s systemic risk as the extent to which it is likely to contribute to a general financial crisis. This measure can be estimated using standard risk-management techniques already used inside banks – but not across banks, as we propose – to weigh how much each trading desk or division contributes to the overall risk of a bank. We set this out in an NYU Stern project on restoring financial stability.

With this measure of systemic risk in hand, a regulator can manage it. We propose two ways to manage systemic risk. First, the regulator would assess each bank’s systemic risk. The higher it is, the more capital the bank should hold. This would seek to ensure that the banking system as a whole had sufficient capital relative to the system-wide risk. This is just like the headquarters of a bank charging each trading desk or division for use of economic capital measured by its contribution to overall firm risk.

Second, each institution would be required to buy insurance against its systemic risk – that is, against its own losses in a scenario in which the whole financial sector is doing poorly. In the event of a pay-off on the insurance, the payment should not go to the company, but to the regulator in charge of stabilising the financial sector. This would provide incentives for a bank to limit systemic risk (to lower its insurance premium), provide a market-based estimate of the risk (the cost of insurance), and reduce the fiscal costs and the moral hazard of government bail-outs (because the company does not get the insurance pay-off). Since the private sector may not be able to put aside enough capital for all the systemic risk insurance, government could provide part of it. Government already provides such partnership on insurance with the private sector in terrorism insurance.

We believe our proposal offers several advantages by explicitly addressing systemic risk based on tools already in use by private companies to manage internal risks. Our proposal is a better way to deal with the trade-off between letting a large institution go bust (Lehman, for example) and causing a global cardiac arrest of the financial system or being forced to spend trillions of dollars of taxpayers’ money to bail out such systemically critical institutions.

Lasse H. Pedersen and Nouriel Roubini are professors at NYU Stern School of Business and the proposed regulation of systemic risk is part of the NYU Stern project "Restoring Financial Stability: How to Repair a Failed System" (John Wiley & Sons, 2009)