• 19 March 2009

Systemic Risk: Revisiting Theory from the Perspective of the “Subprime” Financial Crisis

Steven L. Schwarcz - Duke University School of Law

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My article argues that although banks and other financial institutions (collectively, “institutions”) are important sources of capital, and although a chain of bank failures remains an important symbol of systemic risk, the ongoing trend towards disintermediation—or enabling companies to access the ultimate source of funds, the capital markets, without going through banks or other financial intermediaries—is making these failures less critical than in the past. Companies today are able to obtain most of their financing through the capital markets without the use of intermediaries. As a result, capital markets themselves are increasingly central to any examination of systemic risk. Systemic disturbances can erupt outside the banking system and spread through capital-market linkages, rather than merely through banking relationships.

This has been dramatically illustrated by the subprime crisis. The initial trigger of the cascade of failures that led to this crisis was the historically unanticipated depth of the fall in housing prices.1 Loans to risky, or “subprime,” borrowers were often made with the expectation of refinancing through home appreciation. When home prices stopped appreciating, these borrowers could not refinance. In many cases, they defaulted.2

These defaults in turn caused substantial amounts of investment-grade securities backed by these mortgages to be downgraded and, in some cases, to default.3 Investors began losing confidence in these securities, and their prices started falling. Mark-to-market accounting rules and the high leverage of many firms exacerbated the fall.4

The refusal in mid-September 2008 of the government to save Lehman Brothers, and its resulting bankruptcy, added to this cascade. Securities markets became so panicked that even the commercial paper market virtually shut down, and the market prices of mortgage-backed securities collapsed substantially below the intrinsic value of the mortgage assets underlying those securities.5 Banks and other financial institutions holding mortgage-backed securities had to write down their value, causing these institutions to appear more financially risky, in turn triggering concern over counterparty risk.6

Although the federal government has taken numerous steps to address this collapse, including enacting the Emergency Economic Stabilization Act of 2008, most of its steps to date have focused on institutions, not markets.7 Such a narrow focus worked well when banks and institutions were the primary source of corporate financing. But as the financial crisis reveals, this focus is insufficient now that companies obtain much of their financing directly through capital markets.  

My article argues that institutional systemic risk and market systemic risk should not be viewed each in isolation. Institutions and markets can be involved in both. This integrated perspective is useful because a chain of failures of critical financial intermediaries, by definition, would significantly affect the availability and cost of capital. These failures, therefore, implicitly become a proxy for market consequences. In contrast, a chain of failures of institutions that are not critical financial intermediaries could only significantly affect the availability or cost of capital when those failures are large enough to jeopardize the viability of capital markets.

As disintermediation increases, therefore, systemic risk should increasingly be viewed by its impact on markets, not institutions per se.

 
I.
Analysis

My article focuses on regulating systemic risk. This is a subset of the problem of regulating financial risk. Scholars argue that the primary if not sole justification for regulating financial risk is maximizing economic efficiency. Because systemic risk is a form of financial risk, efficiency should be a central goal in its regulation.

Efficiency has a somewhat unique added dimension in the context of systemic risk. Without regulation, the externalities caused by systemic risk would not be prevented or internalized because systemic risk pertains to risks to the financial system itself. Market participants are motivated to protect themselves but not necessarily to protect the system as a whole. As a result, there is a type of tragedy of the commons, in which the benefits of exploiting finite capital resources accrue to individual market participants, each of whom is motivated to maximize use of the resource, whereas the costs of exploitation, which affect the real economy, are distributed among an even wider class of persons. Any regulation of systemic risk thus should focus not only on traditional efficiency but also on stability of the financial system.

In examining regulatory approaches to systemic risk, one should also take into account the costs of regulation. These can include direct costs such as hiring government employees to monitor and enforce the regulations, and indirect costs such as potential moral hazard. In identifying regulatory approaches, my article takes these costs into account, as well as the goals of efficiency and stability.

After reviewing historical approaches, my article concludes that attempts to regulate systemic risk can be imperfect and messy. Furthermore, the historical focus has been on bank systemic risk and related monetary policy. Modern models of regulating systemic risk should also focus on non-bank and market failures. The article includes these other failures in its focus.

To this end, the article identifies and critiques the following regulatory approaches.

 
A.     Averting Panics

The ideal regulatory approach would aim to eliminate the risk of systemic collapse, ab initio. Theoretically this goal could be achieved by preventing financial panics, since they are often the triggers that commence a chain of failures. I have separately argued that the subprime financial crisis itself was triggered by financial panic.8 Any regulation aimed at preventing panics that trigger systemic risk, however, could fail to anticipate all the causes of the panics. Furthermore, even when identified, panics cannot always be averted easily because investors are not always rational.

 
B.     Requiring Increased Disclosure

Another potential regulatory approach is to require increased disclosure. Disclosing risks traditionally has been viewed, at least under U.S. securities laws, as the primary market-regulatory mechanism. It works by reducing, if not eliminating, asymmetric information among market players, making the risks transparent to all.

In the context of systemic risk, however, individual market participants who fully understand that risk will be motivated to protect themselves but not the system as a whole.9 Imposing additional disclosure requirements may even prove counterproductive, causing market participants to change their behavior. For example, traders may become more cautious, demanding that prices move farther before making trades, thereby ultimately reducing market liquidity.

The efficacy of disclosure is further limited by the increasing complexity of transactions and markets. A contributing factor to the recent subprime crisis, for example, is allegedly that many institutional investors bought mortgage-backed securities substantially based on their ratings without fully understanding what they bought.

The article thus concludes that requiring increased disclosure would do relatively little to mitigate the potential for systemic risk.10

 
C.     Imposing Financial-Exposure Limits

The failure of one or more large institutions could create defaults large enough to de-stabilize other highly-leveraged investors, increasing the likelihood of a systemic market meltdown. This suggests another possible approach to regulation: placing limits on inter-institution financial exposure. Financial-exposure limits would facilitate stability by diversifying risk, in effect by reducing the losses of any given contractual counterparty and thus the likelihood that such losses would cause the counterparty to fail. Limits also might reduce the urgency, and hence the panic, that contractual counterparties feel about closing out their positions.

This approach already applies to banks through lending limits, which restrict the amount of bank exposure to any given customer’s risk. Its application beyond banks to other financial institutions is potentially appealing given the increasing blurring of lines between banks and non-bank financial institutions and the high volumes of financial assets circulating among non-bank financial entities.

It is questionable, though, whether the government should impose financial exposure limits on institutions. Large financial institutions already try to protect themselves through risk management and risk mitigation. The subprime crisis has raised questions, though, whether conflicts of interest among managers and other failures can undermine institutional risk management.11

 
D.     Requiring Reduced Leverage

Requiring reduced leverage could reduce the risk that an institution fails in the first place. It also could reduce the likelihood of transmitting financial contagion between institutions. But requiring reduced leverage create significant costs. Some leverage is good, and there is no optimal across-the-board amount of leverage that is right for every institution.

 
E.     Ensuring Liquidity

Ensuring liquidity could facilitate stability in two ways: by providing liquidity to prevent institutions from defaulting, and by providing liquidity to capital markets as necessary to keep them functioning.

The U.S. Federal Reserve Bank already has the role of providing liquidity to prevent institutions from defaulting, by acting as a lender of last resort. This approach is costly, however. By providing a lifeline to financial institutions, a lender of last resort fosters moral hazard by encouraging these entities—especially those that believe they are “too big to fail”—to be fiscally reckless.12 It also can shift costs to taxpayers since loans made to institutions will not be repaid if the institutions eventually fail.13

The subprime crisis has shown that, in an era of disintermediation, more attention needs to be focused on providing liquidity to capital markets as necessary to keep them functioning.14 This approach should also be less costly than lending to institutions. A market liquidity provider of last resort, especially if it acts at the outset of a market panic, can profitably invest in securities at a deep discount from the market price and still provide a “floor” to how low the market will drop. Buying at a deep discount will mitigate moral hazard and also make it likely that the market liquidity provider will be repaid.15

One might ask why, if a market liquidity provider of last resort can invest at a deep discount to stabilize markets and still make money, private investors won’t also do so, thereby eliminating the need for the market liquidity provider. One answer is that individuals at investing firms will not want to jeopardize their reputations (and jobs) by causing their firms to invest at a time when other investors have abandoned the market. Another answer is that private investors usually want to buy and sell securities, not waiting for their maturities, whereas a market liquidity provider of last resort should be able to wait until maturity, if necessary.16

 
F.     Ad Hoc Approaches

The cost and effectiveness of ad hoc, or purely reactive, regulatory responses to systemic risk are, of course, partly dependent on what those responses turn out to be. Ad hoc approaches do not always work. Sometimes they are too late and the harm has been done or no longer can be prevented, and sometimes there is insufficient time to fashion and implement an optimal solution. 

Nonetheless, the article argues that ad hoc approaches should not be dismissed out of hand. They can help to minimize the difficulties in measuring, and balancing, costs and benefits; and they can reduce moral-hazard cost to the extent an institution cannot know in advance whether, if it faces financial failure, it will be bailed out or fail.

 
G.     Market Discipline

Under a market-discipline approach, the regulator’s job is to ensure that market participants exercise the type of diligence that enables the market to work efficiently. This was the type of approach taken by the United States government under the second Bush administration.

Textbooks claim that perfect markets would never need external regulation, thereby providing support for a market-discipline approach. However actual markets, including financial markets, are not perfect. Furthermore, my article has argued that, even theoretically, a firm can lack sufficient incentive to limit its risk taking in order to reduce the danger of systemic contagion for other firms.

The subprime financial crisis dramatically confirms this argument, that preventing systemic risk through market discipline does not always work. Market discipline may nonetheless be attractive as a supplement to other regulatory approaches.

 
II.
Recommendations and Conclusions

Of the regulatory approaches identified, my article finds that regulation establishing a market liquidity provider of last resort not only should have benefits likely to exceed its costs but also is the approach that would have the best chance of minimizing systemic risk under any number of circumstances. The article recommends that such a market liquidity provider be made operational because market collapses can occur rapidly and without warning.17

The article’s analysis on cost-benefit balancing is not, and in the absence of empirical evidence cannot be, conclusive. All that can truly be said with confidence, the article claims, is that so long as the cost of a systemic meltdown is much greater than the cost of regulation, then regulation should be justified.

This nonetheless provides a useful way of thinking about the cost-benefit balancing because, as the subprime financial crisis has demonstrated, the cost of a systemic meltdown can be catastrophic. Moreover, the article argues, when regulation deals with health and safety issues—as could arise in the case of systemic risk due to its societal impact—the cost-benefit balancing should go beyond strict econometrics. For example, when addressing the risk of catastrophic events or large, irreversible effects where the actual level of risk is indeterminate, regulators often apply a precautionary principle under which they may decide to regulate an activity notwithstanding lack of decisive evidence of the activity’s harm. This same type of precautionary principle, the article argues, should be considered for regulating systemic risk—and thus for assessing the cost-benefit balancing of creating a market liquidity provider of last resort.

Recent experience in the subprime financial crisis supports establishment of a market liquidity provider of last resort. Providing liquidity to the failing mortgage-backed securities markets would have helped to raise the prices of these securities to levels that more closely reflect their real value, bringing back investor confidence.18 With confidence, credit markets would have reopened, mortgage money would have once again become available, and home prices would have begun rising.19

Finally, because financial markets and institutions increasingly cross sovereign borders, the article examines how these regulatory approaches might work in an international context. This examination includes the feasibility of internationally regulating systemic risk, the extent to which a market liquidity provider of last resort or other regulatory solutions are universal or should be different for different countries, and the potential for a regulatory race to the bottom if regulation is done only on a national level.dingbat

 

Acknowledgments:

Copyright © 2009 Georgetown Law Journal.

Steven L. Schwarcz is Stanley A. Star Professor of Law & Business, Duke University School of Law; Founding Director, Duke University Global Capital Markets Center.

Professor Schwarcz’s congressional testimony and his numerous articles on systemic risk and the “subprime” financial crisis are available on his SSRN page at http://papers.ssrn.com/sol3/cf_dev/AbsByAuth.cfm?per_id=33796.

This Editorial is based on the following full-length Article:  Steven L. Schwarcz, Systemic Risk, 97 GEO. L. J. 193 (2008). Click Here for the Full Article.

Because this topic is no longer purely academic, this Editorial revisits the original article’s theoretical framework from the perspective of the current subprime financial crisis—a crisis resulting from a systemic cascade of failures.

  1. Steven L. Schwarcz, Understanding the ‘Subprime’ Financial Crisis, 60 S.C. L. Rev. (forthcoming 2009) (manuscript at 3), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1288687
  2. Id.
  3. Id. at 4.
  4. Id. at 10-11, 21-22.
  5. Id. at 4-5.
  6. Id. at 5.
  7. Id. at 5-6.
  8. Id. at 8 n.24, 22-23; see also supra text accompanying notes 5-6.
  9. This is because of the tragedy of the commons, discussed above.
  10. For a comprehensive analysis of disclosure’s insufficiency, see Steven L. Schwarcz, Disclosure’s Failure in the Subprime Mortgage Crisis, 2009 UTAH L. REV. 1109 (appearing in a symposium issue on the subprime mortgage meltdown), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1113034.
  11. See, e.g., Steven L. Schwarcz, Conflicts and Financial Collapse: The Problem of Secondary-Management Agency Costs, 26 YALE J. on REG. (forthcoming Summer 2009) (appearing in a symposium issue on the future of financial regulation), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1322536.
  12. Schwarcz, supra note 2, at 18.
  13. Id.
  14. See, e.g., Steven L. Schwarcz, Markets, Systemic Risk, and the Subprime Mortgage Crisis, 61 SMU L. REV. 209, 212-14 (2008), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1102326.
  15. The role of a market liquidity provider of last resort might even be able to be privatized.
  16. Schwarcz, supra note 2, at 18.
  17. The article also recommends that establishment of a market liquidity provider of last resort be supplemented by a market-discipline approach, and that to the extent these approaches fail to deter a systemic meltdown, government should seek to prevent the meltdown or mitigate its impact by implementing whatever ad hoc approaches appear, at the time, to be appropriate.
  18. See Schwarcz, supra note 2, at 22-23.
  19. Id.

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