Systemic Risk

Overview

Systemic risk refers to the risk of a breakdown of an entire system rather than simply the failure of individual parts. In a financial context, if denotes the risk of a cascading failure in the financial sector, caused by linkages within the financial system, resulting in a severe economic downturn. A key question for policymakers is how to limit the build-up of systemic risk and contain crises events when they do happen.

Reducing the likelihood and severity of future financial crises can be ensured by a coordinated global effort to monitor market trends and bubbles, and to end government bailouts for failing financial institutions.

Regulation

In the United States, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) created an Office of Financial Research (OFR) to monitor global market developments that might lead to systemic failure. The OFR is part of the US Department of the Treasury and supports the Financial Services Oversight Committee of federal financial regulators. The Financial Stability Oversight Commission (FSOC) directs the OFR and requests data and analyses to support its members’ work. The FSOC also retains authority to deem nonbank institutions as systemically important financial institutions.

Despite warnings in Dodd-Frank that federal bailouts were a thing of the past, Dodd-Frank specifically authorizes the FDIC to guarantee the assets and liabilities of failing financial firms. It also calls on the Fed to create a list of systemically significant firms for special oversight. The FDIC is an independent federal agency created by the US Congress in 1933 in response to the thousands of bank failures that occurred in the 1920s and early 1930s. Its role is to maintain stability and public confidence in the nation's financial system by insuring commercial bank deposits; examining and supervising financial institutions for safety and soundness and consumer protection; making large and complex financial institutions resolvable; and managing receiverships.

A number of European and global entities have undertaken efforts to address systemic risk. For example, the G20 nations agreed to reduce bank leverage by increasing the Basel III capital requirements for financial institutions. The European Union has worked to create a European Financial Stability Facility (EFSF) to provide temporary help to member states regarding fiscal debt burdens and fiscal deficits. The EFSF is a significant part of the 750 billion European Stabilization Mechanism to help member states.

CFA Institute Viewpoint

CFA Institute sponsors the Systemic Risk Council (SRC), composed of US and European market leaders, academics, and former policymakers. As sponsor of the SRC, CFA Institute actively monitors and encourages regulatory reform of systemic risk detection and mitigation in US capital markets, particularly in the areas of bank capital requirements, money market reform, and funding for financial regulators.

CFA Institute also has participated in a G–20 task force charged with making recommendations to harmonize financial regulatory standards worldwide. Regarding the view of CFA Institute on systemic risk:

  • We have called for monitoring of systemic factors on a global basis, and for regulators globally to work together to enable this monitoring.
  • We called for the OFR in the United States to be independent of the member regulators of the FSOC.
  • We are concerned that conflicts of interest inherent in the OFR’s structure—answering to the regulators who may have created policies that are leading to systemic risks—will bias its analyses and that its findings will provide false comfort and cover for FSOC members.
  • We believe that provisions giving the FDIC authority to guarantee the liabilities of failing institutions send a dangerous message to market participants. Specifically, we are concerned that this authority conveys to potential creditors that systemically significant firms continue to be too big to fail, and that their liabilities ultimately will receive federal bailouts to prevent systemic failures.
  • We believe this creates moral hazard within the financial markets and should be replaced by mechanisms that deal with the failure of large financial institutions through a bankruptcy mechanism.
  • Although we support higher capital requirements for financial institutions, including, in particular, large commercial banks, we urge caution in promoting a single global approach to financial market regulation. Such approaches have the potential to encourage coordinated decisions and activities that might exacerbate, rather than diminish, risk on a global basis.
  • We are concerned that the Basel risk-weighting system is based on a static system that ignores the magnitude of the accumulated risks. In particular, the risk weightings continue to apply regardless of whether the exposure amounts to $10 million or $10 billion.
  • We question regulators’ concerns about the systemic risk implications of the asset management industry given, among other things, that asset managers do not own the underlying assets.

 

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