Government Moves Toward Regulation Of Systemic Risk

It is easier said than done. The US government wants to oversee the bank system in a way that would check for the kind of systemic problems that froze the credit markets in late 2008 and nearly ruined the financial industry in America.

The New York Times reports “The Senate and the Obama administration are nearing agreement on forming a council of regulators, led by the Treasury secretary, to identify systemic risk to the nation’s financial system.”

It has yet to be determined how the newly formed group would differentiate between risk which is “local” and that which could disrupt the entire financial system. The government’s plan is to keep an especially sharp eye on the major money center banks such as Bank of America (BAC) and Citigroup (C) and investment banks including Goldman Sachs (GS) and Morgan Stanley (MS). That may work to some extent if the new council tracks the proprietary trades and creation of derivatives, but it still raises the question of what kind of trading and leveraged instruments are dangerous and which are not. Not all derivatives produce unpredictable investment results. Forecasting which ones will is difficult.

The S&L crisis of the 1980s and South American sovereign debt crisis of the 1970s were due to risks that fell outside trading and derivatives. It was nearly impossible to predict that Brazil, Argentina, and Mexico could threaten to default on their debt the same way that it would have been improbable that US regulators could have forecast the sovereign debt problems in Greece two years ago. In other words, systemic risk often sits well outside the purview and anticipation US federal regulators.

The next systemic crisis in the financial and credit markets may be from an inability of Greece or Dubai to pay their debt obligations. US banks already know that their proprietary trading practices are under scrutiny by their boards of directors, auditors, and the Fed. Adding another layer to that scrutiny by creating a new council run by the Treasury Secretary is not likely to detect trouble as it comes over the horizon. And, the most important threats often cannot be forecast at all.

Douglas A. McIntyre