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Coping with Systemic Risk

The Challenge

The global financial crisis has revealed how systemic risk in the banking system can lead to huge economic downturns. Many of the problems leading to the crisis have been discussed and many suspects have been identified (including investment banks, central banks, rating agencies, regulators and the economics profession).

But even with this detailed identification of problems in the financial system, remarkably little has been done to avoid future crises, with the notable exception of Basel III. It should be clear that changing capital requirements alone will be insufficient to stabilize financial markets and avoid future crises.

How should financial market stability be defined? Should central banks aim to monitor financial market stability and take action when necessary? What data are needed to monitor the system? Which stability-enhancing regulatory measures can be realistically implemented?

Should these measures be coordinated internationally to become effective or will national solutions suffice? Is there a risk of over-regulation in the reform process? How should the trade-off be made between the assumed benefits resulting from increased stability of the banking system and the potentially negative impact on global economic growth that will flow from regulatory changes? How is the financial industry likely to respond to these changes?

    Solutions

    Solution

    Central banks’ objectives should include...

     
    Central banks’ objectives should include not only price stability but also financial stability.

    Central banks’ objectives should include not only price stability but also financial stability.

    Polity
    Solution

    Regulators should collect more data...

     
    Regulators should collect more data on financial transactions to assess the repercussions of financial defaults.

    Regulators should collect more data on financial transactions to assess the repercussions of financial defaults.

    Polity, Civil Society
    Solution

    Regulate shadow banks along the...

     
    Regulate shadow banks along the same lines as commercial banks.

    Regulate shadow banks along the same lines as commercial banks.

    Polity
    Solution

    Find an internationally coherent definition...

     
    Find an internationally coherent definition of “systemic importance” (meaning “too big and complex to fail”).

    Find an internationally coherent definition of “systemic importance” (meaning “too big and complex to fail”).

    Polity, Civil Society
    Solution

    Impose minimum standards on loans...

     
    Impose minimum standards on loans (loan-to-value and debt-to-income) to reduce excessive borrowing.

    Impose minimum standards on loans (loan-to-value and debt-to-income) to reduce excessive borrowing.

    Polity, Business

    Proposals

    Proposal

    We must pay much more attention on economic and financial history than we have done before

     
    The latest financial crises showed, once again, that "this time is not different". Many of the excesses and policy mistakes that contributed to the crisis could possibly have been avoided or at least ...

    The latest financial crises showed, once again, that "this time is not different". Many of the excesses and policy mistakes that contributed to the crisis could possibly have been avoided or at least alleviated if we had learnt and remembered the lessons of the history better. According to the history of financial crises, there are several common features in the most severe crises. The biggest crises are usually preceded, among other things, by excessive lending, leverage and maturity transformation, widespread risk illusion, ignorance of tail risks and group-thinking. How to avoid repeating making the same mistakes over and over again?

    Polity, Academia
    Proposal

    Multi-Agent Financial Network (MAFN)Models and Complexity Perspective for Policy Design

     
    1. Why did nobody see it coming? Erosion of the science base in economics confining investigations for decades under the rubric that economic systems are closed and complete rather than complex and ad ...

    1. Why did nobody see it coming? Erosion of the science base in economics confining investigations for decades under the rubric that economic systems are closed and complete rather than complex and adaptive along with ‘group think’ evident in top economic journals, departments and key policy institutions such as the IMF, are major ingredients in the recent crisis. The paradigm shift needed and the skills gap among economists that has to be fixed is quite considerable to enable us to deal with a longstanding failure of economists and the regulatory bodies to keep abreast of the institutional and technological innovations

    Academia
    Proposal

    Consistent macroeconomic policies that eliminate negative real interest rates and unsustainable debts are a precondition for a stable financial system

     
    It is well known that the banking system, by its nature, is particularly vulnerable to economic crisis; It is naive, however, to attribute these vulnerabilities solely to a lack of a more consistent r ...

    It is well known that the banking system, by its nature, is particularly vulnerable to economic crisis; It is naive, however, to attribute these vulnerabilities solely to a lack of a more consistent regulatory framework. There were important gaps: insufficient capital of poor quality, “shadow” institutions out of the reach of supervision, a remuneration structure that creates incentives to arbitrage and opacity in key financial vehicles. The main failure, however, has been the effective implementation of existing requirements and standards; What it is at stake is the quality and efficiency of Banking Supervision, particularly among industrialized countries; The focus should

    Polity
    Proposal

    Regulating Leverage and Risk

     
    Economic theory shows us that there is an important externality in financial markets. Banks and other financial institutions have the incentive to make leveraged investments. That is, a bank can incre ...

    Economic theory shows us that there is an important externality in financial markets. Banks and other financial institutions have the incentive to make leveraged investments. That is, a bank can increase its expected return when making loans to an investment project by borrowing much of the money from other banks. However, by doing this, it imposes risk on those other banks -- if the project fails, not only is the bank jeopardized itself, but so are its creditors -- and it has no incentive to take account of this imposed risk. For that reason, there is a natural tendency

    Polity, Business
    Proposal

    Macroprudential policy must curb excessive use of debt in the economy and in the financial system, taking account of various manifestations of excessive debt

     
    The key reasons for most financial crises are excessive growth in assets and excessive debt, which, in essence, are the different sides of the same coin. In the recent crisis, in addition to the mortg ...

    The key reasons for most financial crises are excessive growth in assets and excessive debt, which, in essence, are the different sides of the same coin. In the recent crisis, in addition to the mortgage boom in many countries, especially in the US, the excessive use of short-term debt within the financial sector itself turned out to be the most dangerous form of debt. At the same time, effectively very thin equity buffers were allowed in the banking sector. The true fragile state of the financial system was then largely missed by the authorities and investors. The crisis experience hence

    Polity, Academia
    Proposal

    Coping with Systemic Risk

     
    Part 1: Why do regulators know so little about the empirical network structure of the interbank market? What data is needed to monitor the system? Is it possible to monitor systemic risk, based on mar ...

    Part 1: Why do regulators know so little about the empirical network structure of the interbank market? What data is needed to monitor the system? Is it possible to monitor systemic risk, based on market data only? An important reason for the lack of knowledge (interest?) in detailed interbank networks, is the usage of mainstream economic models, of the Dynamic stochastic general equilibrium (DSGE) type. DSGE models neglect the importance of complexity and heterogeneity and policymakers thinking in terms of these models essentially assume a very robust banking system having no feedback on the macroeconomy and vice versa. In

    Polity, Academia, Business, Civil Society
    Proposal

    Macroprudential policy must be coordinated between countries in order to avoid inaction

     
    I argue that in the absence of strong regional or international coordination of national macroprudential policies, the combination of these policies will be dangerously weak in preventing the future g ...

    I argue that in the absence of strong regional or international coordination of national macroprudential policies, the combination of these policies will be dangerously weak in preventing the future global financial crises. There are two main reasons for my prediction. First, there is a well known problem of "taking the punch bowl away in the middle of the party", which makes the containment of financial excesses politically difficult at a national level. Second, there is an additional "first-mover disadvantage problem", which aggravates the "punch bowl problem" in an integrated financial market. The first-mover disadvantage problem is caused by an inability

    Polity, Academia
    Proposal

    Macroprudential authorities need to learn to take the punch bowl away

     
    We need more analysis on the reasons, probably including political economy aspects, why policy makers often seem to fail to interfere with potentially dangerous economic and financial developments bef ...

    We need more analysis on the reasons, probably including political economy aspects, why policy makers often seem to fail to interfere with potentially dangerous economic and financial developments before it is too late. Part of the problem may concern mandates and available policy instruments. But it is probably the case that even if mandates and responsibilities are clear and effective instruments are available, the risk of inaction or under-reaction is still there. The problem may also result from the regulatory capture if the industry to be regulated has too strong an influence on the decisions of the regulator. If this

    Polity, Academia

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