SeekerBlog

There is a way that a “systemic risk regulator” could be useful — but only if the data on firms positions is available to the regulator. Here is why:

The more we understand about our wrecked financial system, the greater the clamor for a systemic-risk regulator. We want someone to save us from ourselves — or from the financial engineers who could blow the whole thing up again a few years down the road. Demand for a risk regulator, an idea that arose from the Treasury Department early last year, has now been embraced by the Group of 20 nations. Everyone wants a cop on the beat. But what would such a regulator do that the hodgepodge of current regulators cannot?

To answer that question, let’s first understand what we mean by systemic risk, and why it needs to be monitored. Systemic risk is driven largely by leverage. Leverage — borrowed money — is the force that amplified risk in the meltdown. Investment banks that once borrowed $10 for every dollar of equity were allowed to boost that to more than $30. As for hedge fund leverage, well, we can only guess. When a market downturn forces such highly leveraged investors to sell to meet their margin requirements, a crisis can cascade quickly. Selling pushes prices down, leading in turn to more forced selling.

The downward momentum is just the start of the problem. Many of those under pressure discover they no longer can sell in the market that is under stress. If they can’t sell what they want to sell, they have to sell whatever else they can, which leads to a downward spiral. This phenomenon explains why a crisis that started in the hinterland of subprime mortgages spread through the credit markets generally.

This contagion can expand beyond natural economic links. When the silver bubble burst in 1980, for example, the price of cattle suddenly came under pressure. Why? Because when the Hunt family had to meet margin calls on their silver positions, they sold whatever else they could. And they happened also to be invested in cattle.

To regulate systemic risk, then, we must understand systemic leverage, crowding (that is, when many speculators move into the same trade, pushing up prices in the process) and aggregated position holdings. Whatever their own risk-management capabilities, individual institutions cannot protect against systemic risk because they do not have this broader information. It is as if each player is sitting in a theater unaware of the others who might run for the exit.

Continue reading… for Rick Bookstaber’s proposal, published originally in Institutional Investor magazine.