8 - Measuring Systemic Risk

Summary

Abstract The most important lesson from the financial crisis of 2007 to 2009 has been that failures of some large financial institutions can impose costs on the entire system. We call these systemically important financial institutions (SIFIs). Their failures invariably put regulators in a compromised situation since, absent prearranged resolution plans, they are forced to rescue the failed institutions to preserve a functioning financial system. In the recent crisis, this has involved protecting not just insured creditors, but sometimes uninsured creditors and even shareholders. The anticipation that these bailouts will occur compromises market discipline in good times, encouraging excessive leverage and risk taking. This reinforces the systemic risk in the system. It is widely accepted that systemic risk needs to be contained by making it possible for these institutions to fail, thus restraining their incentives to take excessive risks in good times. First and foremost, however, regulators need to ascertain which institutions are, in fact, systemically important. Indeed, the systemic risk of an individual institution has not yet been measured or quantified by regulators in an organized manner, even though systemic risk has always been one of the justifications for our elaborate regulatory apparatus.

There are some institutions that follow highly cyclical activities and are thus heavily correlated with aggregate economic conditions. If these institutions are also highly levered, especially with short-term debt, then they face runs in the event of sufficiently adverse news about their condition.