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Systemic Risks and Macroprudential Bank Regulation: A Critical Appraisal

Journal 33: Technical Finance

David VanHoose

This article discusses and critically appraises recent developments in the definition, measurement, and regulation of systemic risks. Although the issue of systemic risks has been subjected to considerable study, there is not widespread agreement on how to define the concept of systemic risk. Initial efforts to measure systemic risks emphasized aggregate financial ratios, and only recently have a variety of institution-level systemic-risk measurement techniques been proposed and studied.

Thus, regulators charged with conducting macroprudential regulation, such as the Financial Stability Oversight Council created by the Dodd-Frank Wall Street Reform and Consumer Protection Act, must act without a consensus about how to define and measure the form of risk they are charged with limiting. Furthermore, there are three largely unexplored pitfalls associated with establishing a macroprudential-supervision apparatus: (1) an enlarged potential for regulatory capture and associated welfare losses; (2) a danger of over-relying on centralized governmental command-and-control mechanisms that might be at least as subject to breakdowns as private markets while underrelying on private market discipline; and (3) failures to contemplate a role for private contractual (Coasian) solutions to externality problems that contribute to systemic-risk problems and to recognize that a broadened scope of regulations can actually undermine the incentives for financial institutions to contain these externality problems. Future research should explore these issues, which have generally not been addressed in the literature on systemic risk and macroprudential regulation.

The U.S. Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 in the wake of the Panic of 2008 and clearly with an eye to at least some recommendations offered by academic economists [see, for instance, Kern et al. (2006), Acharya and Richardson (2009), French et al. (2010), Feldman and Stern (2010), and Dewatripont et al. (2010)]. This law created a Financial Stability Oversight Council (FSOC) to “make recommendations to the [Federal Reserve’s] Board of Governors concerning the establishment and refinement of prudential standards and reporting requirements…[i]n order to prevent or mitigate risks to the financial stability of the United States that could arise from the material financial distress or failure of large, interconnected financial institutions.” Supermajority votes of the FSOC can designate certain firms as “systemically important” or to grant the Federal Reserve authority to require firms to divest assets to avert a “grave threat” to U.S. financial stability. The law also charges the FSOC with resolving disagreements among member agencies, collecting information for monitoring potential risks to the overall U.S. financial system, and identifying threats to financial stability.

This feature of the Dodd-Frank Act has established the first effort in U.S. history to identify, measure, and regulate systemic risks generated by activities of financial and nonfinancial firms, and the FSOC is the nation’s first body charged with macroprudential regulation, or regulation focused on the banking and financial system as a whole as well as on the performance of individual institutions. What are systemic risks, and how might they be measured? How might macroprudential regulation and supervision be implemented within the banking industry?3 Why might there be potential pitfalls associated with the establishment of a macroprudential regulation superstructure? These are the key questions addressed in this article.

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