On Systemic Risk

by: David Merkel, CFA

There are five factors for systemic risk:

  1. Asset size of the institution, including synthetic exposures.
  2. Degree of leverage of the institution, including synthetic exposures.
  3. Asset-Liability mismatch, particularly financing long assets with short liabilities (including derivatives and margin agreements — think of AIG or mortgage REITs on repo).
  4. Degree to which the institutions own financial companies equity or debt, or vice-versa, where other financial companies have claims on the institution in question.
  5. Riskiness of the assets owned by the institution in question.

Contributing to the risks is easy monetary policy, which can lead/has led to the neglect of risk control. Personally, if I were a regulator of systemic risk, I would throw my effort at companies that fit factors 1 and 2, and analyze them for the other three factors.

Systemic risk is layered levered credit risk. A lent to B, who lent to C, who lent to D, who financed a bunch of bad mortgages.

#5 is underwriting risk.

#4 is connectedness risk.

#3 is liquidity risk.

#2 is financial risk.

#1 is risk to the economy as a whole.

So when I read articles like this, or books about systemic risk by academics that are so bad that I don’t want to review them (set them to work picking fruit; it would be more valuable than what they currently do), I simply say systemic risk is easy. Look at my five points. You can eliminate systemic risk by:

  • Breaking up the big banks. (1)
  • Disallowing banks from owning the equity of other financials and vice-versa. (4)
  • Forcing strict asset-liability matching at banks (3), and
  • Sizing capital to the riskiness of loans made. (2,5)
  • Move to double liability on banks — they can’t be limited liability corporations. Investors and managers must have their net worth on the line for any losses.

This isn’t hard, but the banks will scream. Let them scream, and let the stocks of the banks fall. Banks take risks beyond what they ought to because of poor regulation. They should be regulated well, and have lower returns on equity as a group.