Systemic Risk: The Mother of All Risk & How Not To Manage It

From an early age one is taught “the bigger they are the harder they fall.” So it is that the TBTF or Too- Big-To-Fail label has taken hold in the lexicon, except that the focus is on the size, not so much the reasons for the “fall”.  The proposed Volker Rule, which aims to limit the size of banks so they can be OKTF or OK-To-Fail, as I am now calling it, doesn’t appear to be gaining much traction.  Would it have been better for the economy and the taxpayer if, say, at the expense of keeping the bulge bracket banks and others in business, 3,000 small banks went under instead of only the 140 small bank failures that occurred in 2009?

On the surface it should be easier to regulate and monitor a few large institutions in real-time to assess the risk they pose to the system and to themselves rather than the thousands of smaller institutions that are separate and distinct.  We know from history that banks, large or small, will pretty much be driven to do the same thing, so is failure of any size really an option in today’s global, interconnected economy?

This month is the two-year anniversary of the over-the-weekend acquisition of Bear Stearns by JP Morgan Chase, and outside of making some adjustments to mark-to-market accounting language, not much progress has been made on containing systemic risk.   Instead of just doing a quick fix on the CDS market or deploying an overall reform of all OTC derivatives, the legislation is moving slowly in the Senate.  Instead of increasing capital requirements or other means to reduce excessive leverage that got banks into this mess, more focus is on bank profits and bonuses.  It’s hard to believe there is even a debate on the need for or formation of a consumer protection agency, whether or not we believe how effective it can be.  And the last minute Volker Rule changed priorities and fueled the banking lobby even further.

Systemic risk cannot be prevented and time should be spent understanding how to spot it in advance and how to manage it effectively when it happens.  But it’s a zero sum game and somebody has to pay for failure and ultimately, that someone is always us.