One Issue Two Voices

1 Systemic Financial Risk: CAN NEW REGULATIONS PROTECT THE PUBLIC FROM WIDESPREAD ECONOMIC FAILURE? ANITA ANAND + STEVEN L. SCHWARCZ ONE ISSUE TWO VOICES ISSUE 18 MAY 16 INTRODUCTION: The One Issue Two Voices series they focus on financial institutions, not financial presents a dialogue between two leading experts in markets, and are constrained by national jurisdictional their fields from Canada and the United States to boundaries. Complexity of financial markets is also an discuss a policy area of importance to the two coun- impediment to stabilization efforts, as is moral hazard, tries. Through this dialogue, the Canada Institute i.e. market participants engage in risky behavior seeks to identify areas of convergence and divergence because they don’t bear the full cost of that behavior. and lay the groundwork for future policy recommen- In the Canadian context, Anand argues that while dations. In this report, Anita Anand and Steven L. it is true that Canadian capital markets weathered Schwarcz assess the options for mitigating systemic the financial crisis better than their peers, there are a financial risk in both Canada and the United States. number of aspects of the Canadian system that can give The regulatory systems in the two countries provide rise to systemic instability. For instance, even though a unique lens through which to explore systemic risk Canada’s regulatory framework helped to safeguard since the systems are broadly interconnected but also against contagion, certain risk sources augmented separated by a number of regulatory distinctions. the scale of the crisis. In the case of Asset-Backed The multiple failures that triggered the 2008 Commercial Paper, for example, issuers were exempt global financial crisis changed the way businesses from certain disclosure and supervision requirements and governments view risk. The Economist notes that and ratings agencies approving the securities for financiers who believed that they had found a way to distribution were unregulated. banish risk had instead “simply lost track of it.”1 Rather Anand agrees with Schwarcz that consumer than breakdowns of individual institutions, systemic protection is not the central concern of the individuals risk refers to the probability of breakdown of an entire supervising the system. Prudential regulators seek to system, and highlights the vulnerability that arises limit risk taking by financial institutions and central from the interdependence inherent within the global banks seek to reduce risk system wide. Nevertheless, financial system. she argues, the effects of both central banking and The cascading dynamic that transformed individual prudential regulation are to ensure that consumers failures into a global financial crisis has led policy are protected. Anand raises the question of whether makers to consider more closely the nature of systemic Canada needs an entity to provide comprehensive financial risk and to the consider various regulatory oversight of systemic risk and what changes to the instruments and institutions to prevent a replay of the status quo might be needed to ensure more effective crisis. supervision. Anand also emphasizes the importance of In his briefing, Schwarcz argues that financial coordination among regulators both within and across institutions and financial markets can trigger and countries. transmit financial risk that could lead to the collapse Finally, one of the most important areas of of the system. Regulation helps to protect investors convergence between the two authors is the recognition against fraud, maintain competition and correct that governance of financial institutions is different market failures. from that of a public corporation and that financial While recognizing the importance of regulation, regulators have a duty to avoid risk taking that could Schwarcz concludes that recent attempts at regulating systemically harm the public. systemic financial risk such as the U.S. Dodd Frank Act fall short for a number of reasons, including that 2 ONE ISSUE TWO VOICES Steven L. Schwarcz MANAGING SYSTEMIC RISK: AN AMERICAN VIEW Beginning in 2007, an unanticipated fall in American SOURCES OF SYSTEMIC RISK housing prices triggered a cascade of failures as mortgage borrowers defaulted on their loans and invest- There has been confusion about the sources of sys- ment-grade securities backed by these mortgages were temic risk. Historically, economists and other scholars downgraded. When the U.S. government refused in discussed it primarily in terms of banks. More recently, 2008 to step in with multi-billion-dollar loans to bail they have included other financial institutions in the out Lehman Brothers—the fourth largest investment discussion. This still-limited focus assumes that banks bank in the United States—Lehman’s bankruptcy and other financial institutions are the primary source caused the short-term commercial paper market to vir- of corporate financing. However, the financial crisis tually shut down, and banks and other financial insti- revealed that businesses access much of their funding tutions holding mortgage-backed securities had to write directly from capital markets without going through down their value even further. Lehman’s bankruptcy intermediary institutions—a process known as “disin- 2 also caused many of the highly leveraged firms that had termediation.” We now know that both financial insti- been doing business with Lehman—its counterpar- tutions and financial markets can be triggers and also ties—to appear risky, and in the panic that ensued, the transmitters of systemic risk, leading to the potential fire sale of their assets exacerbated the overall fall in collapse of the financial system. prices. By systemic risk, I refer to an economic shock (such These events had massive worldwide ramifications, as a market or institutional failure) that triggers a) in part due to finance’s increasingly global interconnec- the failure of a chain of markets or institutions or b) tions. In our borderless financial world, the international a chain of significant losses to financial institutions. financial system can collapse like a row of dominos. In These failures result in increases in the cost of capital or the years since, much has been written about systemic decreases in its availability. risk in the hope that an understanding of its causes and how best to curb it will prevent similar crises from hap- REGULATING SYSTEMIC RISK pening again. Textbooks claim that perfect markets would never need external regulation, but history proves that markets, including financial markets, are not in themselves These events had massive worldwide perfect. At times, government intervention is necessary. ramifications, in part due to finance’s Regulation of systemic risk has traditionally focused on preventing bank failures. Banks are required to hold increasingly global interconnections. minimum levels of capital, for example, and the U.S. In our borderless financial world, the Federal Deposit Insurance Corporation (FDIC) serves to prevent bank runs by alleviating fears that banks will international financial system can default on deposit accounts. Going forward, how else collapse like a row of dominos. should systemic risk be regulated? ISSUE 18 MAY 16 3 In considering that question, it is important to keep The Dodd-Frank Act in mind that regulation can be expensive. Government Amid the angst on how best to avoid another “Great or government-delegated employees have to be hired Recession,” in July 2010 the Obama administra- to enforce the regulations. Regulation can sometimes tion passed the Dodd-Frank Wall Street Reform and produce unintended negative consequences—such Consumer Protection Act4 (commonly known as Dodd- as a reduction in the number of transactions and Frank)—an enormous set of new laws designed to restraints on both innovation and the natural evolu- minimize financial risk through tight regulations on tion of markets. In addition, regulation that protects key financial institutions. All told, it represents the against the results of risky behavior can motivate even most drastic change in U.S. financial regulation since more risk-taking, in the anticipation that government the Great Depression of the 1930s. intervention or bailout loans will likely prop up failing To list but a few of its provisions, the Dodd-Frank companies. In contemplating more regulation, we have Act stipulates new ways to dissolve large, “systemi- to ensure that its costs do not exceed its benefits. cally important” banks and other financial institutions Because systemic risk is a form of financial risk, one (SIFIs) without the need for government bailouts, justification for its regulation is to maximize economic including requiring them to submit a “resolution plan” efficiency—to maintain competition, protect investors that sets out how, in the event of financial failure, they against fraud and other abuses, prevent externalities, would wind down in a way that minimizes systemic and correct market failures. For that reason, the goal impact. In addition, it attempts to improve disclosure, of U.S. securities laws (as of similar laws worldwide) standardizes some derivatives transactions and requires is efficiency. In addition to risks within the financial them to be implemented through clearing houses, system, however, systemic risk focuses on risks to the limits SIFIs’ ability to engage in “proprietary trading” financial system. As such, the regulatory regime must (investing in securities for their own

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