I define systemic risk as the risk that the failure of a financial institution will significantly impair credit intermediation throughout the financial system. Since credit is the mother's milk of economic activity, the failure of a systemically important financial institution will seriously damage the economy.

Whether an institution presents a systemic risk depends on:

§         The extent of its relationships with other institutions and financial markets;

§         The complexity of those relationships and its other activities;

§         Its global reach;

§         Its stature within the financial system.

An institution with extensive, complex relationships throughout the global financial system and that plays a prominent role in that system poses a systemic risk. As is now evident, an institution's systemic importance is not determined by its corporate structure; it can be a depository institution, a broker-dealer, a hedge fund, an insurance or pension company, and so on.

This crisis has also made it evident that an uncomfortably large number of financial institutions are too big to fail. The desire to break up these institutions is understandable, but ultimately futile. There is no going back to the era of Glass-Steagall; breaking up the banking system's mammoth institutions would be too wrenching and would put U.S. institutions at a distinct competitive disadvantage vis-à-vis their large global competitors. Large and complex financial institutions are also needed to efficiently finance and backstop the rest of the financial system.

A major failing of the current regulatory framework is that regulators lack the authority and tools to mitigate systemic risk. A systemic risk regulator to oversee the entire financial system is much needed to require all financial institutions to hold more capital, meet stiffer liquidity requirements, disclose necessary information, and pay deposit and perhaps other insurance premiums commensurate with the risks they pose to the entire financial system. The Federal Reserve seems best suited for this task, given its central position in the global financial system, its considerable financial and intellectual resources, and its political independence.

Regulators also currently lack the ability to gracefully resolve systemically important financial institutions headed toward failure. Indeed, it was regulators' missteps with Fannie Mae and Freddie Mac, Bear Stearns, Lehman Brothers, and AIG that created the confusion that turned what should have been a manageable financial crisis into a panic. Regulators need a special resolution mechanism that would be triggered only if all the nation's key regulators agreed that it was needed. This collective approach should allay concerns that regulators would invoke this special authority too readily, thereby increasing moral hazard and ultimately generating more failures and greater costs to taxpayers. Besides, regulators have long been making life-and-death decisions over depository institutions, and history suggests that, if anything, regulators have long shown too much forbearance.

Policymakers should accept the reality that systemically important institutions are an integral part of the financial system. With the right regulatory framework, these institutions can be appropriately managed and, if things go wrong, resolved in an orderly way. Not embracing this responsibility will ultimately lead to a less stable and efficient financial system and slower economic growth.

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Although it’s possible to define systemic risk in words, it is impossible to know in advance whether the failure of a particular financial firm will cause a systemic breakdown.

 Our inability to predict whether a particular firm’s failure will have systemic effects has important policy implications. The administration has proposed that the government have authority to take over and resolve all financial firms that are likely to cause systemic instability if they fail. If we give the government this authority, we should recognize that officials will not be able to tell when it is appropriate to use it, nor will Congress or the public have any idea whether it was properly used. What is clear, however, is that without any guidance—or any way of telling the difference between a failure that will cause a systemic breakdown and one that will merely cause a temporary economic disruption—officials are likely use their authority liberally. After all, it is better to be safe than sorry, and regulators know they will be blamed when a company’s failure causes economic disruption, ut praised when they step in to save an important firm from bankruptcy.

 The frequent use of this authority (which we might call Lehman-phobia) will introduce moral hazard, as investors and creditors come to assume that large firms will be rescued while small ones will be allowed to fail; market discipline will be impaired, and large firms will gain competitive advantages over small ones. The costs to taxpayers are also likely to be substantial.  Since the purpose of the takeover is to prevent a failure from causing a systemic breakdown, the failed firm will have to be kept operating, with the government furnishing the funds.  AIG is a good example of how these takeovers will work. In fact, one can think of the whole system as a kind of permanent TARP, with the government having the authority to bail out firms that officials believe will cause systemic breakdowns without any way of determining whether that judgment was correct.

 We would not be disarmed if the administration’s proposal were abandoned. In reality, only the failure of a large commercial bank can create a systemic event, because only banks hold funds that businesses and the public need for immediate use. If a bank fails payrolls are frozen and checks are not honored. This can send a cascade of losses through the economy, but does not happen when a nonbank financial firm fails. No business keeps its payroll at a securities firm or a “Tier One holding company.” Losses are suffered, to be sure, but over time, and mostly by diversified creditors who can and should take them.  The aftermath of Lehman’s failure was not a systemic breakdown, but the result of what is called a “common shock”--a surprise to market participants that causes them to recalibrate their risks. After the rescue of Bear Stearns, market participants had assumed that all financial institutions larger than Bear would also be backed by the government. When that didn’t happen, it was necessary for banks and others to review the financial strength of their counterparties, causing the freeze-up in lending and hoarding of cash that has been incorrectly labeled as a systemic breakdown. If we focus regulation and resolution authority only on commercial banks, the FDIC and the Fed already have the tools necessary to prevent systemic breakdowns in the only place—the banking system—where they will ever occur. This will require no change in current law except a substantial strengthening of bank capital requirements.  

 Systemic risk is a concept. As Justice White said of pornography, we might know it when we see it. But it would be a major policy error to use it as a guide for giving the government new and unrestricted authority to take over nonbank financial institutions.

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