On Systemic Risk

There are five factors for systemic risk.  Here they are:

  1. Asset size of the institution, including synthetic exposures.
  2. Degree of leverage of the institution, including synthetic exposures.
  3. Asset-Liability mismatch, particularly financing long assets with short liabilities (including derivatives and margin agreements — think of AIG, or mortgage REITs on repo).
  4. Degree to which the institutions owns financial companies equity or debt, or vice-versa, where other financial companies have claims on the institution in question.
  5. Riskiness of the assets owned by the institution in question.

Contributing to the risks include easy monetary policy, which can lead/has led  to the neglect of risk control.  Personally, if I were a regulator of systemic risk, I would throw my effort at companies that fit factors 1 and 2, and analyze them for the other three factors.

Systemic risk is layered levered credit risk. A lent to B, who lent to C, who lent to D, who financed a bunch of bad mortgages.

#5 is underwriting risk

#4 is connectedness risk

#3 is liquidity risk

#2 is financial risk

#1 is risk to the economy as a whole.

So when I read articles like this, or books about systemic risk by academics that are so bad that I don’t want to review them (set them to work picking fruit, it would be more valuable than what they currently do), I simply say systemic risk is easy.  Look at my five points.  You can eliminate systemic risk by:

  • Breaking up the big banks. (1)
  • Disallowing banks from owning the equity of other financials and vice-versa. (4)
  • Forcing strict asset-liability matching at banks, and  (3)
  • Sizing capital to the riskiness of loans made. (2,5)
  • Move to double liability on banks — they can’t be limited liability corporations.  Investors and managers must have their net worth on the line for any losses.

This isn’t hard, but the banks will scream.  Let them scream, and let the stocks of the banks fall.  Banks take risks beyond what they ought to because of poor regulation.  They should be regulated well, and have lower returns on equity as a group.

About David Merkel 144 Articles

Affiliation: Finacorp Securities

David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website RealMoney.com (http://www.RealMoney.com). Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I still contribute to RealMoney, but I have scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After one year of operation, I believe I have achieved that.

In 2008, I became the Chief Economist and Director of Research of Finacorp Securities. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm.

Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.

I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

Visit: The Aleph Blog

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