The Hansen framework I offered in the last post remains a good starting point for thinking about sources of systemic risk, and points to some of the problems regulators face in regulating systemic risk. This is not to say that Hansen’s list offers (or even claims to offer) a complete set of risk factors. But his three dimensions of Concentration, Interconnectedness and Behavior provide a useful basis for thinking about the individual threads that combine to create the complexity that makes systemic risk such a problem.
But before I get to that, I think it would be useful to consider some of the ways regulators have tried to address each of the three sources of risk.
As the table shows, treating each risk separately leads to very different regulatory approaches. If regulators focus on concentration, then the obvious solution is to limit both the absolute and relative size of a given organization. This rational solution has been rendered a non-starter due to the political power of the financial sector (though the Fed’s Fisher is trying).
Instead, regulators have considered a range of policies designed to increase the resiliency of institutions to losses by raising credit and liquidity standards, layering on shock-absorbing buffers, and other features. In the wake of the failure of Lehman Brothers, regulators have also been focused on developing guidelines and clarifying jurisdiction in terms of winding down or “resolving” a failing institution as a worst case.
By contrast, focusing on interconnectedness implies a completely different regulatory response that emphasizes controlling, reducing or even eliminating the linkages between institutions. Doing this is much easier said than done, given the lack of data on the networks created by transactional flows both across and within national banking systems (as this Vox paper by Cerutti et al. explains).
An even greater challenge is that these linkages can span regulatory jurisdictions, requiring a level of harmonization that seems impossible to achieve even within a single country. The ongoing tussle between the SEC and the CFTC over the regulation of index swaps – a structure that ties together securities, futures and swap markets – is only one of several examples.
The final source of risk is notably the only one that stems from the behavior of people, rather than the structure of the overall system. The policy response is also different in that it imposes costs directly on individuals while generally letting the institutions that benefit from their business off the hook.
The real value of this three-part framework, in my view, is the way it reduces the welter of new regulation into some more easily understandable. It also shines a light on what regulators choose not to regulate when claiming to address systemic risk, which can be especially useful.
That’s a lot easier to see in the context of a specific example.
Example: Money Market Funds
The recent push by regulators to address systemic risk emanating from money market funds (MMFs) is a case in point. One of the ugliest surprises of the 2008 credit crisis was the extent to which the financial sector relied on borrowing in short-term markets to fund its longer-term investment activity. Money market funds are the biggest single source of funding for these markets, so the run on these funds in the wake of the collapse of Lehman shone a spotlight on the fragility of this aspect of the financial system.
Although it’s not necessary to go into all of the details, a brief list makes the extent of the problem quite clear – MMFs look bad in all three dimensions:
Regulators have taken a few passes at controlling these risks. The first measures were emergency plans put in place by the Fed and Treasury in 2008, though these were temporary, and have since expired.
The next pass at reform came in 2010, when the SEC took the “de-risking” approach I described above by implementing a series of measures aimed at making the funds themselves more resilient to market shocks (MoFo offers a helpful summary). These reforms tightened the rules for credit quality, liquidity and other features inherent in MMF portfolios.
While these rules were a necessary step forward, they left unaddressed the instability created by the illusion of a “stable” NAV. More important, they left the overall concentration of the industry untouched, and did not address the dense linkages between MMFs and the broader financial system.
More recently, the SEC attempted but failed to address the remaining structural issues with two proposals. The Financial Stability Oversight Council (FSOC) then stepped in with its own proposal, which is currently in an extended comment period.
This is already a very long post so I won’t go into too much detail, but there are several characteristics of the FSOC’s document that merit discussion. First, it includes a comprehensive overview of the risks related to various aspects of the industry, including its size, scale and interconnectedness. Second, it distils these into two central problems of instability and uncertainty relating to the illusion of a stable NAV, as well as the lack of loss-absorption capacity of MMFs.
The remainder of the document can be seen as a sort of menu of possible policy alternatives to address these problems, either alone or in combination. It will be fascinating to see how the rules end up being implemented, because each menu choice only addresses one risk. For example, imposing liquidity fees would put all the costs on shareholders and only addresses behavioral risk, while creating a capital buffer to absorb instead puts all the costs on fund companies (more or less), and offsets some of the concentration risk in the Hansen framework.
The proposal is also interesting in terms of what it leaves unaddressed. After describing them in great detail in the introduction, the proposed rules don’t mention the concentration of the MMF industry or its tight linkages to the financial system again. Not only does this narrow the policy space of possible solutions – it also makes clear what is and sn’t politically possible when creating new rules for the investment industry.
There’s much more to say about MMFs but that’s of interest to a tiny group of people, so I will end here. Up soon – complexity.