kingaj12

Systemic Risk Is Unmanageable

The bottom-line question appears to be what to do during the inflationary build-up that preceeds (or triggers) a deflationary crisis. According to Minsky, the financial sector inevitably transitions from conservative lending (when liquidity is plentiful), to speculative activity (when liquidity is scarce and and risk-taking is well-rewarded), and finally to outright Ponzi schemes like subprime securitization.

We need to make all this financial scheming pay in advance for the liquidity that these schemes depend on. The reserve banking system has in effect sold a "put" option on the equity of the financial sector: a systemic bank rescue restores the balance sheets of the financial system so it can be viewed as the payout of a put option on bank equity. The marginal change to the cost of hedging this put option can be attributed to changes in bank positions, and some percentage of this change can be charged back to the banks in the form of a systemic risk haircut, or some such device.

Even if one got the calculation wrong (a reasonable assumption!) systemic risk haircuts would supply a counter-cyclical pressure on leveraged financial risk-taking. Moreover such attributions can be scaled based on a reasonable view of the fundamentals. Financial institutions taking large leveraged positions in crowded markets are making use of a social good (liquidity). Liquidity is not free. If they paid for it up front then maybe, just maybe, their behavior would change.