Systemic Risks and Macroprudential Bank Regulation: A Critical Appraisal

This paper 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 this concept. 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. 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. There are 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 under-relying 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.