Systemic risk refers to the risk of a breakdown of an entire system rather than simply the failure of individual parts. In a financial context, it denotes the risk of a cascading failure in the financial sector, caused by linkages within the financial system, resulting in a severe economic downturn. A key question for policymakers is how to limit the build-up of systemic risk and contain economic crises events when they do happen.
Reducing the likelihood and severity of future financial crises can be ensured by a coordinated global effort to monitor market trends and bubbles, and to end government bailouts for failing financial institutions.
CFA Institute sponsors the Systemic Risk Council (SRC), a group of global experts advocating for stronger oversight and reform in U.S. capital markets, focusing on bank capital, money market stability, and financial regulator funding.
Regulation of Systemic Risk
In the United States, the Dodd-Frank Wall StreetReformand ConsumerProtectionAct (Dodd-Frank) created an Officeof Financial Research (OFR) tomonitor globalmarket developmentsthatmight lead tosystemic failure.TheOFR is partof theUS Department of the Treasuryand supports the Financial ServicesOversight Committeeof federal financial regulators. The Financial Stability Oversight Commission (FSOC) directstheOFRand requests data and analysestosupportits members’ work. The FSOC alsoretains authority todeemnonbank institutions as systemically important financial institutions.
Despite warnings inDodd-Frank thatfederalbailoutswerea thingof the past, Dodd-Frank specificallyauthorizes theFDIC toguarantee the assets and liabilitiesof failing financial firms.It alsocalls on the Fed tocreate a list of systemicallysignificant firms for specialoversight. The FDIC is an independent federalagency created by theUS Congress in 1933in response tothe thousands ofbank failures thatoccurred in the 1920s andearly1930s. Its roleis tomaintainstability and public confidence in the nation's financial system by insuring commercial bank deposits;examiningand supervising financial institutions forsafetyand soundnessand consumer protection; making large and complex financial institutions resolvable;andmanaging receiverships.
A numberof European andglobal entities have undertaken efforts toaddresssystemicrisk.For example, the G–20 nationsagreed toreduce bank leverage by increasing theBasel III capital requirements for financial institutions.The EuropeanUnion hasworked tocreate a European Financial Stability Facility (EFSF) toprovidetemporary help tomemberstates regarding fiscal debt burdensand fiscal deficits. TheEFSF is asignificant partof the€750 billion EuropeanStabilizationMechanismto help memberstates.
CFA Institute Viewpoint
CFA Institute sponsors the Systemic Risk Council (SRC), composed of US and European market leaders, academics, and former policymakers. As sponsor of the SRC, CFA Institute actively monitors and encourages regulatory reform of systemic risk detection and mitigation in US capital markets, particularly in the areas of bank capital requirements, money market reform, and funding for financial regulators.
CFA Institute also has participated in a G–20 task force charged with making recommendations to harmonize financial regulatory standards worldwide. Regarding the view of CFA Institute on systemic risk:
- We have called for monitoring of systemic factors on a global basis, and for regulators globally to work together to enable this monitoring.
- We called for the OFR in the United States to be independent of the member regulators of the FSOC.
- We are concerned that conflicts of interest inherent in the OFR’s structure—answering to the regulators who may have created policies that are leading to systemic risks—will bias its analyses and that its findings will provide false comfort and cover for FSOC members.
- We believe that provisions giving the FDIC authority to guarantee the liabilities of failing institutions send a dangerous message to market participants. Specifically, we are concerned that this authority conveys to potential creditors that systemically significant firms continue to be too big to fail, and that their liabilities ultimately will receive federal bailouts to prevent systemic failures.
- We believe this creates moral hazard within the financial markets and should be replaced by mechanisms that deal with the failure of large financial institutions through a bankruptcy mechanism.
- Although we support higher capital requirements for financial institutions, including, in particular, large commercial banks, we urge caution in promoting a single global approach to financial market regulation. Such approaches have the potential to encourage coordinated decisions and activities that might exacerbate, rather than diminish, risk on a global basis.
- We are concerned that the Basel risk-weighting system is based on a static system that ignores the magnitude of the accumulated risks. In particular, the risk weightings continue to apply regardless of whether the exposure amounts to $10 million or $10 billion.
- We question regulators’ concerns about the systemic risk implications of the asset management industry given, among other things, that asset managers do not own the underlying assets.