On February 25, 2014, the Berkeley Center for Law, Business and the Economy (BCLBE) hosted a lunchtime talk on Systemic Risk and the Financial Crisis by Prof. Steven L. Schwarcz. Prof. Schwarcz is a Professor of Law & Business at Duke University and is well known for his research and scholarship in the area of financial regulation and systemic risk. In his lecture, Prof. Schwarcz focused on how regulations should address systemic risk – “the risk that the failure of financial markets or firms harms the real economy by increasing the cost of capital or decreasing its availability.”
Prof. Schwarcz differentiated between two forms of regulations to control systemic risk: microprudential and macroprudential.
Microprudential regulations focus on correcting interrelated market failures that trigger systemic risk, such as, information failure, rationality failure, principal-agent failure and incentive failure. Information failure is attributed to the increasing complexity of the financial markets, which creates mutual misinformation on both sides of transactions. He referred to the securitization of Collateral Debt Obligations where such misinformation occurred because neither the investors nor the originators fully comprehended the consequences of these investments.
Rationality failure occurs due to the inherent human nature to oversimplify reality and to be unrealistically optimistic, which is aggravated by the herd mentality and the propensity to panic. Principal-agent failure deals with the longstanding agency issues between management and ownership. Here, Prof. Schwarcz introduced an interesting discussion about misalignment of interests and information asymmetry between secondary management and senior management. Lastly, incentive failure occurs when investment diversification by firms marginalizes risks so they lack the incentive to perform sufficient due diligence with regard to specific investments.
On the other hand, macroprudential regulations embody the larger goal of protecting the financial system as a system. It involves two simultaneous approaches. First, the regulations limit the triggers of systemic risk. Second, they limit the transmission and impact of the shocks of systemic risk, if it occurs. The common triggers of systemic risk are maturity mismatches and financial panic, which is always associated with a bank run. These triggers, he said, were exacerbated by profit driven management decisions backed by limited liability, which assures that in case of a collapse, much of the harm would be externalized. Prof. Schwarcz recommends that limited liability be redesigned to better align investor and social interests.
Further, Prof. Schwarcz explained three ways of limiting the impact of systemic risk. They include providing liquidity to the firms and markets, requiring the firms to be more robust, and ring-fencing. To ensure liquidity, firms should create systemic risk funds to internalize externalities. In addition to increasing liquidity and providing bailout monies, this will also encourage firms to cross-monitor risky behavior. Prof. Schwarcz stated that the law should also compel firms to be more robust by setting capital and solvency requirements. Prof. Schwarcz further explained ring-fencing regulations that could effectively insulate firms from risks. The Volcker Rule and the now repealed provisions of the Glass-Steagall Act, which limited affiliation between commercial and investment banking activities, are examples of ring-fencing regulations.
In conclusion, Prof. Schwarcz suggests that none of these approaches are foolproof by themselves but both the microprudential and macroprudential regulations could provide an effective framework for controlling systemic risk.