Getting to the Source of Systemic Risk

Recent articles on the US and world economic crisis have often been focused on the concept of ‘systemic risk’. For example, Robert Pozen, author of Too Big to Save?, argues in The Wall Street Journal (7/9/09) that the Federal Reserve ought to be given the job of monitoring systemic risk. What this refers to is certain kinds of financial ‘products’ and practices that have often graced the headlines of late: credit default swaps, collateralized debt obligations, and other kinds of credit derivatives.

The idea that the financial crisis has been caused by exotic new financial instruments—from credit derivatives to adjustable rate mortgages—has become part of the conventional wisdom. But is it true?

No doubt there is always a tendency to find fault in new practices that seem to be responsible for disasters, such as humbling the titans of finance with billions of dollars of losses, charmingly called ‘write-downs’. But how does that lead to systemic risk? If a large corporation (financial or otherwise) loses billions or even hundreds of billions, how does that threaten the system as a whole? Well, corporations often owe money to other corporations, and perhaps if a large lender goes under, other firms are placed at risk. That does indeed sound bad. But how is it different from the usual course of events? Companies rise and fall. Taking risks can lead to success or failure. When an idea leads to a failure, that strategy tends to be repeated less than those that are successful. A failure, even a large one, poses no threat to the system. Failures are an integral part of the system. Even the largest corporations are subject to market forces. And thank goodness for that. Big corporations must be exquisitely sensitive to quality and reputation, or else they are at risk of losing market share and potential takeover.

In the same way that nature rewards certain kinds of risks and penalizes others—successful strategies lead to greater propagation of a species—an evolutionary market-based process is the best enforcer of risk. The Fed or any regulator will always be 10 steps behind. Even if the government regulator happens to be on time, what should the penalty be? Will such penalties be subject to political forces—such as those that determined that Lehman should fail while Bear Stearns or AIG is rescued?

The nature of markets is the equalization of risk and return. Risky activities ought to have high returns, while less risky activities yield lower returns. Financial markets are filled with risky products that are hundreds of years old. Short-selling (the practice of borrowing shares in order to buy them back later, hopefully at a lower price) exposes the seller to potentially unlimited risk. Out of-the-money options that are close to expiration are also extremely risky. But these options are priced accordingly, not by government regulators, but by the market.

Yet even when markets are functioning well, it’s true there is a systemic risk lurking. At any moment, banks could collapse, for their reserves are only a tiny fraction of their deposits. Any threat to the banking sector sets off a damaging spiral: bank failure leads to bank runs, leading to loss of faith in banks, leading to further contraction in lending and paralyzing the conduit that runs from savings to investment.

This is why economists Kotlikoff and Leamer argue for a new financial architecture, one that does away with this source of systemic risk once and for all, while channelling society’s savings into investment, and providing prices for financial assets that correctly equalize risk and return. (See “A Banking System We Can Trust”, Forbes, 4/23/09). Their brilliant proposal would essentially to do away with the fractional reserve system. Unfortunately, this proposal has received little attention or discussion in the US. I get the sense we’re sick of the topic here. We’d rather believe in the green shoots that are supposedly sprouting. They say ‘less bad’ is the new ‘good’. My guess is that as the rally fades and new risks to the system are revealed, there will be an surge of interest in reforming the fractional reserve banking system, the source of systemic risk to the economy.

Bernanke on Financial Innovation

While there are legitimate financial innovations, e.g. the stock market, options, shorting stocks - many financial innovations are merely more sophisticated ways to gamble or rip someone off.

Fed chair Ben Bernanke offers an interesting argument about three financial innovations that he considers worthwhile and important. These are: credit cards, mortgages, and bank overdrafts.

There is a certain wolf-in-sheep's-clothing aspect to Bernanke's speech.

He says, in effect, gosh, some of these financial innovations haven't gone all that well. It's very challenging for regulators, because on the one hand, we don't want to stifle innovation, because that makes all our lives better. On the other hand, sometimes things get out of hand, we ought to consider how these innovations will react when they are "stressed", and recognize that regulation may be needed. Who could argue with these mild-mannered banalities?

Yet if we step back and ask the question, why should the Fed have a role to play in preventing people from getting fleeced? That doesn't seem like the Fed's role. People get ripped off all the time. It seems to me that a better defense against that than the Fed could ever be is this device called the internet. It sure seems like a great way to spread information to other consumers not to do things that end up being a huge rip-off.

And why would the Fed place restrictions on financial activity at all? We already have laws against fraud. What else is needed?

We have to recognize that the Fed has an impossible task: to prevent a house of cards from collapsing. The fractional reserve system is fundamentally insolvent. This is what creates a danger to financial stability in the first place. The reason that somebody not paying their mortgage may mean I lose my job is because banks are running the biggest fraud in history, an epic pyramid scheme that makes Bernie Madoff seem insignificant. And the job of the Fed is to oversee this fraud, to make sure that we keep it up, to continue to shovel an ever-increasing share of society's surplus value into the coffers of the banks. This is why it strikes me as rather disingenuous for Ben Bernanke to worry that complex mortgage products may not ultimately help the consumer. Talk about dodging the real issue.