It Takes A Citi

Washington-based policy tinkerers seem increasingly drawn to the idea that greater reliance on market information can forestall future problems – e.g., providing input into an early warning system that can be acted upon by a “macroprudential system regulator”. And while leading critics of the administration’s proposed approach to rating agencies make some good points, they also seem to think that the market tells us when big trouble is brewing.

The history of Citigroup’s credit default swap (CDS) spread is not so encouraging.

It’s true that in some instances during the past two years, CDS spreads have indicated pressure points, e.g., within types of lenders or across countries. And if you can tell me how Citi survives going forward with a CDS spread around 450 basis points, I would be grateful.

The people who price CDS obviously have every interest in assessing risk in a hard headed and accurate manner. But Greenspan’s Lament applies to CDS traders just as much as to incentives within mismanaged banks – where in the Citi CDS spread chart do you see the build up of risk through the end of 2006? If anything, the market for default probability was saying that Citi – and by implication the financial system with all its growing subprime vulnerabilities – was becoming less risky.

You can hope that, in the future, the market will not be so generally exuberant, but 400 years of modern financial history begs to differ.

The WSJ gets this right: regulatory capture is not only pervasive, it is by design. But what’s the implication?

All regulators must ultimately fail and, when that happens, markets may well also misprice risk. The question is: When this Twin Failure occurs next time, how much will be on the line?

You cannot design a financial system that is immune to crash – this would be like declaring earthquakes illegal. But in the aftermath of unexpectedly high damage from a serious earthquake, it makes sense to completely overhaul your building code and retrofit vulnerable buildings. In fact, if you largely ignored what the earthquake revealed in terms of structural weakness, wouldn’t that be negligence?

About Simon Johnson 101 Articles

Simon Johnson is the Ronald A. Kurtz (1954) Professor of Entrepreneurship at MIT's Sloan School of Management. He is also a senior fellow at the Peterson Institute for International Economics in Washington, D.C., a co-founder of, a widely cited website on the global economy, and is a member of the Congressional Budget Office's Panel of Economic Advisers.

Mr. Johnson appears regularly on NPR's Planet Money podcast in the Economist House Calls feature, is a weekly contributor to's Economix, and has a video blog feature on The New Republic's website. He is co-director of the NBER project on Africa and President of the Association for Comparative Economic Studies (term of office 2008-2009).

From March 2007 through the end of August 2008, Professor Johnson was the International Monetary Fund's Economic Counsellor (chief economist) and Director of its Research Department. At the IMF, Professor Johnson led the global economic outlook team, helped formulate innovative responses to worldwide financial turmoil, and was among the earliest to propose new forms of engagement for sovereign wealth funds. He was also the first IMF chief economist to have a blog.

His PhD is in economics from MIT, while his MA is from the University of Manchester and his BA is from the University of Oxford.

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