Systemic Risk and the Financial Crisis

1. Prepared by: Cas Hughes Eric Kennedy Craig Behrens Systemic Risk and the Financial Crisis

2. What is systemic risk? • The risk to the health of the entire financial system posed by the failure of one or more systemically important financial institutions.

3. When did it surface in the financial crisis? • Systemic Risk fears caused the following: • The forced sale of Bear Stearns to J.P. Morgan. (March 2008) • The Government’s takeover of AIG. (September 2008) • The Federal Government guaranteeing money market funds after the Reserve Primary Fund “broke the buck”. (Due to Lehman Brothers failing in September 2008). • The conservatorship of the housing GSE’s (Fannie and Freddie, October 2008). • The creation of TARP to provide funding in the banking system. ($700 billion, October 2008) • The Federal Government temporary expansion of deposit insurance for bank deposits. (It went from guaranteeing of $100,000 to $250,000, until December 31st, 2013.)

4. Systemic Risk Regulator • Should there be a systemic risk regulator and if yes who should be in charge of the SRR? • The Federal Reserve? • NO! Since they are already involved in monetary policy, the situation might arise where they have to choose between the regulation on monetary policy(1. price stability 2. unemployment) or systemic risk. (For example, the Federal Reserve could choose to reduce asset bubbles, which could result in unemployment skyrocketing.) • A consolidation of the OCC, FDIC, and OTS into a Financial Solvency Regulator, with a division specifically dedicated to Systemic Risk Regulation? • We believe this is the best alternative. First off, it would eliminate power struggles of jurisdiction associated with banking agencies, because the solvency regulator would have the final say on all decisions regarding systemic risk within the financial sector. Also, it would help relieve the Fed of systemic risk management, which would allow them to focus primarily on monetary policy. But we believe the Fed should still act as the lender of the last resort, therefore this agency would have quarterly meetings with the Fed to discuss the systemically important financial institutions.

5. What should the SRR Job entitle? • Reduce systemic risk • Must develop a criteria to measure systemic risk and to indentify systemically risky firms, including some insurance agencies which would be regulated at the Fed level for the first time.(Insurance Companies solvency would be covered at the Federal level). • The SRR should propose strategies for firms to encourage them to lose the title of being “Systemically Risky” and to reduce the taxes imposed on their current risk level.

6. What should the SRR job entitle? Cont. • They should impose tougher Capital and Liquidity requirements on “Systemically Risky” firms than those that are not deemed systemically risky. • Should have regular/quarterly meetings with the Fed to discuss the findings of new SIFIs and how other SIFIs are doing. • Develop not only size based measure to determine systemically risky firms but also market-based measures. • Address problems associated with derivative markets. • They should create a rescue or pre-bankruptcy plan upon determining that a firm is highly undercapitalized but not yet insolvent.

7. How will the SRR measure risk? • Asset size alone is not enough to measure systemic risk. • Why? • Just because a firm is big does not mean it is necessarily systemically risk. (i.e.- asset size does not measure the riskiness and interconnectedness of the assets.) • We believe that asset size should be combined with a market-based measure.

8. Marginal Expected Shortfall (MES) • MES- prediction of how much a financial company’s stock will decline if the market, as a whole, declines 2% in one day. • This measure illustrates a firm’s volatility and correlation with the market as well as how the firm performs in extreme situations.

9. ERISK • Equity Risk for a firm in a crisis. • ERISK= MES x Debt/Equity • The results show capital shortfalls a firm would face in a financial crisis.

10. Systemic Risk Contribution • SRISK%, is the percentage of all capital shortfall that would be experienced by a firm in the event of a crisis. • The higher a firms SRISK%, means that this firm is not only riskiest by itself, but also it means that it is more systemically risky as a whole to the economy. • NYU used this measure to perform an analysis to determine the top 10 systematically risky financial institutions.

11. Top 10 Systemically Risky Firms According to NYU Stern Rankings

12. Regulation of Systemic Risk • Impose taxation on firms deemed “systemically risky”. • 1. Based on DES (expected losses in default, to the extent that those losses are insured by the government). • 2. Based on banks perceived contribution to systemic risk that is calculated by the firms SES. (Systemic expected shortfall= expected systemic costs when the financial sector becomes undercapitalized * Fin institutions % contribution to the undercapitalization). • Impose tougher capital and liquidity requirements on firms that are systemically risky. • Also the SRR should go away from pro-cyclicality of current requirements because it constrains lending in bad times and causes excess lending in good times. Also, standards need to be clearly stated, if not regulators may relax them in bad times and then not raise them in good times. This could result in undercapitalized firms which would increase the systemic risk associated with the financial institutions. • Regulation of derivative markets. • Such as making CDS (which caused the failure of AIG) and other currently traded OTC derivatives go through a clearinghouse to eliminate counterparty risk. Also set minimum collateral requirements for the clearinghouse and reporting requirements to improve transparency associated with derivatives.