Systemic risk is very dangerous for economy, as we have seen in last 200 years majority of the financial failure occurs due to systemic risk. In United States’ history from the founding of the republic until 1933 it experienced banking panics roughly every fifteen to twenty years. When the Great Depression struck, it was “in a league of its own in severity” and the banking system near to collapse, government responded with federal intervention into the marketplace including creation of federal deposit insurance, securities regulation, banking supervision, and the separation of commercial and investment banking under the Glass-Steagall Act. This happens because of systemic risk involved in the system where failure of one bank leads to failure of another and every banks are interrelated which causes nearly total banking system failure.
However US govt. followed implicit strategy where they insured and regulated the most systemically dangerous part of the system, the commercial banks, and exercised a much lighter touch elsewhere, leaving the rest of the financial system to innovate, be dynamic, and do everything that markets do so well.
This has worked for US govt. for the next 50 years, they didn’t see any crisis during that period however significant financial failures returned to the marketplace in the late 1980s with the savings and loan crisis, followed by a rash of bank failures in the early 1990s that forced the government to recapitalize the FDIC’s Bank Insurance Fund. Long Term Capital Management, a largely unregulated hedge fund, came perilously close to collapse in 1998, threatening the global financial system. The tech bubble burst in 2001. Accounting scandals destroyed Enron in 2001 and WorldCom in 2002. And the current global financial crisis, the worst since the Great Depression, has yet to run its course.
As the country experienced no major financial crises for the longest period in the history lawmakers not only weakened or dismantled New Deal-era regulations, they also failed to enact new regulations to keep up with financial innovation spurred by technology and globalization of markets. Over time, a huge amount of financial activity migrated away from regulated and transparent markets and institutions and into the lightly regulated or unregulated shadow markets encompassing mortgage brokers, hedge funds, private-equity funds, off-balance sheet structured-investment vehicles, and a booming market in opaque derivatives, especially credit-default swaps. By the summer of 2007, the Treasury Department estimates, the shadow banking system had accumulated assets reaching roughly $10 trillion, equivalent to total assets in the entire U.S. banking system.
While new systemic threats had emerged along the way, there was little effort to regulate them, undercutting the original New Deal strategy of targeting such threats. As a result, the American financial system was left more vulnerable than ever to a major shock.
Today, financial institutions deemed too big to fail already have a huge marketplace advantage – hundreds of billions of federal bailout funds unavailable to smaller firms in financial trouble. That gives big, complex firms a dramatic advantage that is inappropriate.
Since last fall, there’s also an implicit guarantee of government rescue for any firm that in the future may be identified as too big to fail. “What’s worse, these firms impose costs on society by creating systemic risks that they don’t have to bear on their balance sheets.
Implicit strategy has worked for the govt. in the past however it has created a trend where every big company feels that they can be protected by government whatever they do. This makes them to create more systemic risk by spreading their wings beyond the limit in the form of high leverage and overlooking regulated procedures etc.
After the Great Depression & till mid eighties there were not very risky financial innovation due to which even little unregulated environment doesn’t create panic. But after mid-eighties we have seen lot of volatile & risky financial innovations like mortgage brokers, hedge funds, private-equity funds, off-balance sheet structured-investment vehicles, derivatives and securitization etc. which requires healthy regulated environment but lawmaker & govt. always overrule it and these innovations were highly unregulated that ultimately causes biggest crisis since the Great Depression.
In order to protect future of financial market, government should follow Explicit Strategy rather than implicit. Following steps need to be taken-
• First, identify industry/firm/sector that poses systemic risk and then replace unlimited implicit guarantee with government defined limited explicit guarantee for the first time.
• Second, companies that create systemic risk should bear the cost of insuring against it, just as commercial banks pay into an FDIC insurance pool. And the government should insist on appropriate capital standards and liquidity requirements to limit the type of risks that these firms impose on society.
• Third, creating a receivership process would allow an efficient handling of failed companies. It really need to change the perception that no institution is too big to fail. In this process all systemic institutions would get limited support during a period of economic turbulence but if that turns out not to be enough then they are going to be taken into the receivership process and liquidated or restructured.
One thing that we don’t fully understand that the world in which we live right now will continues. It’s one of massive implicit guarantees that are open-ended, we need to be honest about these implicit guarantees, to define and limit them. That’s the purpose of this whole proposal, not to put systemic firms at a competitive disadvantage but rather to prevent them from imposing undue costs on the rest of the financial system.
“Implicit approach enhances systemic risk, Explicit approach controls and reduces”
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