Wednesday, March 25, 2009

The mythical "Systemic Risk"

Does anyone have a definitive idea on what "systemic risk" is?   If so, should we even try to regulate it as it is now obvious that existing regulatory regimes and human nature have shown otherwise.

The solution is to acknowledge that many believe that there is the existence of systemic risk, but that it cannot be controlled.  Prudence, in the sense of being prepared for things that we cannot predict or forecast, should be the guiding principle.

There should be two frameworks - regulatory and non.   Two rules for non-regulated:  Cannot be a publicly traded company and will not get bailed out.  In other words, these non-regulated firms would normally be partnerships where the owners have all their capital at risk and then some.   They are generally free of oversight except that they will not be bailed out.  

The regulated companies have their deposits and custodial accounts guaranteed for a fee.  In return, they are limited in the amount of leverage they may use,  cannot use off balance sheet financing, and cannot engage in trading from their own account except as a market maker (i.e. no proprietary trading).   The only derivatives that these firms may trade are those that go through a clearinghouse with adequate margin rules.

This keeps the "traditional" banking and investment banking side in their roles, but limits their leverage and scope of business in return for being insured by the government.   The other players not covered are the wild West, whereby the players are on the hook for their losses and are not publicly traded (think the big 4 CPA firms or Goldman Sachs before it went public as a structural model).  

Think this is fair enough for everyone to understand ..

2 comments:

Hershblogger said...

Mitch,

The more I've considered this question the more I think the most serious risk, and it's clearly systemic, is the American voter.

Mitch said...

Human nature is what it is. As James Grant once wrote about a physics phd setting up a quant fund is that the laws of physics are constant because God is the constant. Economic quant models will fail because they cannot predict changes in behavior that to many people, is self-evident.

Mass hysteria and group psychology is running wild.