Sunday, September 12, 2010

Regulating Systemic Risk

By Steven L. Schwarcz and Iman Anabtawi

Abstract: Systemic risk management is at the forefront of financial regulatory agendas worldwide. The global financial crisis was a powerful demonstration of the inability and unwillingness of financial market participants to carry out the task of safeguarding the stability of the financial system. It also highlighted the enormous direct and indirect costs of addressing systemic crises after they have occurred, as opposed to attempting to prevent them from arising. Governments and international organizations are responding with measures intended to make the financial system more resilient to economic shocks, many of which will be implemented by regulatory bodies over time. These measures suffer, however, from the lack of a theoretical account of how systemic risk propagates within the financial system and why regulatory intervention is needed to disrupt it. In this Article, we address this deficiency by examining how systemic risk is transmitted. We then proceed to explain why, in the absence of regulation, market participants are poorly situated to disrupt the transmission of systemic risk. Finally, we advance a regulatory framework for correcting that market failure.

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