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Technical Capabilities Necessary for Regulation of Systemic Financial Risk: Summary of a Workshop (2010)

Chapter: 3 Observations from the Workshop's Keynote Presentations

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Suggested Citation:"3 Observations from the Workshop's Keynote Presentations." National Research Council. 2010. Technical Capabilities Necessary for Regulation of Systemic Financial Risk: Summary of a Workshop. Washington, DC: The National Academies Press. doi: 10.17226/12841.
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3
Observations from the Workshop’s Keynote Presentations

The workshop keynote presentation by Andrew Lo of the Massachusetts Institute of Technology began by looking broadly at the causes of crises in other technology-based sectors besides the financial sector, such as aerospace, nuclear power, and transportation. He echoed Perrow,1 who studied accidents and concluded that they are a normal phenomenon of complex, nonlinear systems with tight coupling. Human behavior is an important contributor in many cases, and many complex systems embed human decision making. Lo added that, in addition to tight coupling and complexity, a third necessary condition for a crisis to develop is the absence of negative feedback over an extended period of time.

Lo pointed out that simply losing a great deal of money is not what defines a systemic risk. He contrasted the current crisis, which has cost the country $1.5 trillion, with the major stock market movement on April 14, 2000, when the market lost $1.04 trillion. No one considers the latter event to have been systemic, even though it involved losses on the same scale as those of the current crisis. The difference is that people who invest in the stock market expect some downturns and were presumably aware of the risk prior to April 14, 2000. A characteristic of systemic events is that they result in losses among people who were not expecting them and were unprepared.

Many ideas have been developed for reducing systemic risk. Lo listed 14 possible policy responses that academics, policy makers, and other observers have proposed in light of the financial crisis (see Box 3.1). He observed that, over the next several years, the nation will be rebuilding its financial infrastructure for the future and it needs more, not less, financial expertise. Systemic risk can be measured, and people have made steps in that direction. The data available for early warnings were suggestive but not conclusive, and so more has to be done to develop an understanding that is clear and reliable enough to use in managing the financial system. All of this suggests that people with strong expertise in engineering and quantitative modeling are critical to addressing the challenge.

1

Charles Perrow. 1984. Normal Accidents: Living with High Risk Technologies. New York: Basic Books.

Suggested Citation:"3 Observations from the Workshop's Keynote Presentations." National Research Council. 2010. Technical Capabilities Necessary for Regulation of Systemic Financial Risk: Summary of a Workshop. Washington, DC: The National Academies Press. doi: 10.17226/12841.
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BOX 3.1

Some Possible Steps for Reducing Systemic Risk in the Financial Sector

  • Break up banks and broker/dealers that are “too big to fail.”

  • Create exchanges for credit default swaps and other large over-the-counter contracts.

  • Create an equivalent of the National Transportation Safety Board or National Weather Service for analyzing blowups and monitoring risks.

  • Require confidential disclosure regarding “network” exposures.

  • Implement countercyclical leverage constraints for bank-like entities.

  • Enforce “suitability” requirements for mortgage-broker advice.

  • Require certification for management and boards of complex financial institutions.

  • Impose more mark-to-market accounting and risk controls.

  • Impose capital adequacy requirements for all bank-like entities.

  • Create a new discipline of “risk accounting.”

  • Impose a small derivatives tax to fund financial engineering programs.

  • Revise laws to allow “pre-packaged” bankruptcies for finance companies.

  • Change corporate governance structure (compensation, role of the Chief Risk Officer, etc.).

  • Teach economics, finance, and risk management in high school.

SOURCE: Adapted, with permission, from Andrew Lo, Massachusetts Institute of Technology, presentation at the Workshop on Technical Capabilities Necessary for Regulation of Systemic Financial Risk, Washington, D.C., November 3, 2009.

Myron Scholes of Stanford University gave a keynote presentation that discussed the costs of adjusting portfolios when conditions change. Flexible portfolios are more expensive and less profitable. One must pay for an option that gives flexibility, and the option price is high when volatility and illiquidity are high or may become high. Leverage is inherently inflexible because positions cannot easily be sold in a downturn to pay off the debt. Illiquidity also rises in a crisis. In the run-up to the current crisis, too much leverage was taken by consumers, investors, governments, corporations, and financial entities, making the system unstable.

Scholes noted that the cost of the bailout should be compared with the costs of proactive solutions such as tighter regulation. It is possible that the bailout is less expensive. Systemic financial risk regulators are essentially risk aggregators. He believes that many systemic risks can be identified by careful aggregation of firm risk measures. This must be dynamic, as the value of liquidity provision varies over time. Stable-value products are inherently unstable and might be a source of systemic risk. Debt convertible to equity when triggered by systemic events might be an important tool for increasing flexibility. Accounting must be improved to reduce the impact of false profits and short-run compensation. Overall, firms should hold bigger capital cushions. Regulation to ensure this could improve everyone’s welfare. Incentives and monitoring must work together to reduce the possibility of systemic failures.

The keynote presentation by Robert Engle of New York University discussed the financial crisis in terms of two features—the failure to assess risks adequately and the incentives to ignore

Suggested Citation:"3 Observations from the Workshop's Keynote Presentations." National Research Council. 2010. Technical Capabilities Necessary for Regulation of Systemic Financial Risk: Summary of a Workshop. Washington, DC: The National Academies Press. doi: 10.17226/12841.
×

risks for many market participants. Solving the incentive problems has been the primary goal of regulatory reform. Solving the risk assessment problem is at the heart of the workshop discussions.

To measure risks of individual firms and systemic risks of the financial system as a whole requires both data and models. Models of volatility predict the magnitude of short-run price movements. Over longer horizons, there is a possibility that the risk itself will change, or at least that the volatilities will change. Thus, long-term risk measures must reflect the way that risks are likely to change. Counterparty exposures are important systemic risks in the over-the-counter derivatives markets, and these can be managed by a combination of central clearing, collateral contracts, and improved transparency.

Regulators should have access to counterparty exposures and position data in Engle’s view. In this way, models can predict the impacts of stresses that flow through networks of counterparties and positions ultimately affecting the whole system. His talk discussed new research on systemic risk measures. Such measures can be constructed from public information or, with more precision, from nonpublic information. He argued that systemic regulators should be given access to these data and, in the meantime, should continue to develop models of systemic risks based on public financial data.

Suggested Citation:"3 Observations from the Workshop's Keynote Presentations." National Research Council. 2010. Technical Capabilities Necessary for Regulation of Systemic Financial Risk: Summary of a Workshop. Washington, DC: The National Academies Press. doi: 10.17226/12841.
×
Page 14
Suggested Citation:"3 Observations from the Workshop's Keynote Presentations." National Research Council. 2010. Technical Capabilities Necessary for Regulation of Systemic Financial Risk: Summary of a Workshop. Washington, DC: The National Academies Press. doi: 10.17226/12841.
×
Page 15
Suggested Citation:"3 Observations from the Workshop's Keynote Presentations." National Research Council. 2010. Technical Capabilities Necessary for Regulation of Systemic Financial Risk: Summary of a Workshop. Washington, DC: The National Academies Press. doi: 10.17226/12841.
×
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The financial reform plans currently under discussion in the United States recognize the need for monitoring and regulating systemic risk in the financial sector. To inform those discussions, the National Research Council held a workshop on November 3, 2009, to identify the major technical challenges to building such a capability. The workshop, summarized in this volume, addressed the following key issues as they relate to systemic risk:

  • What data and analytical tools are currently available to regulators to address this challenge?
  • What further data-collection and data-analysis capabilities are needed?
  • What specific resource needs are required to accomplish the task?
  • What are the major technical challenges associated with systemic risk regulation?
  • What are various options for building these capabilities?

Because every systemic event is unique with respect to its specific pathology—the various triggers and the propagation of effects—the workshop focused on the issues listed above for systemic risk in general rather than for any specific scenario. Thus, by design, the workshop explicitly addressed neither the causes of the current crisis nor policy options for reducing risk, and it attempted to steer clear of some policy issues altogether (such as how to allocate new supervisory responsibilities). More than 40 experts representing diverse perspectives participated in the workshop.

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