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Economic Brief
july 2009, EB09-07

systemic risk regulation
and the “Too Big to Fail”
By Borys Grochulski and stephen slivinski

A single regulator tasked with preventing
threats to systemic stability would need to
have considerable power and discretion.
But creating such a powerful entity
could reinforce the moral hazard problem
resulting from the idea that some firms
are too big to fail.

The financial crisis that started in the summer of 2007 has spurred
many academics and policymakers to suggest that a new "systemic risk
regulator" (SRR) is necessary. The most extensive proposal to date was
the one released by President Obama's administration on June 17.1
It would create a Financial Services Oversight Council chaired by the
Secretary of the Treasury and composed of the heads of the major
federal financial regulators. It also would assign the SRR function to
the Federal Reserve, subject to the Council’s oversight. The goal of the
SRR and the Council would be to prevent or mitigate a future financial
crisis or systemic shock. To fulfill this goal, the Council and the Fed
would be given substantial power to regulate and resolve trouble
in systemically important financial institutions.
The question of what form the optimal regulation of the financial
system should take is enormously complicated. What constitutes
“systemic risk” is neither precisely understood nor widely agreed upon,
so mitigating such risk is inherently difficult. Yet, perhaps more important, any proposal to give a regulatory body the task of heading-off
threats to systemic stability must cope with how that entity would
interact in practice with the market expectation of how the government treats firms deemed “too big to fail” (TBTF).
In this Economic Brief, we are not focused on discussing a particular
policy proposal. Instead, our goal is to examine one narrow aspect
of the interaction between an SRR and the market’s expectations
about the government’s approach to TBTF firms, and to describe the
consequences that might result. As we argue, there is a danger that
tasking a government body with regulating systemic risk and giving
it substantial discretion and power to act on what it sees as threats to
market stability could actually exacerbate the marketplace behaviors
that precipitated the creation of an SRR in the first place.

EB09-07 - ThE FEdEral rEsErvE Bank oF richmond

ThE TBTF ProBlEm and GovErnmEnT rEGulaTion oF
It is well-understood that the market’s perception of the TBTF status
of some large financial institutions has profound effects on the risktaking incentives of those institutions.2 The TBTF perception can alter
the relationship between the financial institutions’cost of credit and
the riskiness of the assets they fund with this credit. To see why, recall

that senior creditors take a loss on their investment only when the
institution to which they have loaned money fails outright. If those
bondholders perceive that the government views the failure of that firm
as unacceptable, they can be practically assured repayment. This means
that they are willing to extend credit to the financial institution cheaply
since they expect to be made whole by the government in the case of
the firm’s inability to repay.
At the same time, the institution has the incentive to allocate the
bondholders’funds to projects with a large profit potential regardless
of the downside risk. This is because the upside value goes to the
shareholders if the risk pays off, while the downside is borne by others.
This creates a clear incentive to take on risks that are imprudent. This
incentive is often referred to as the“moral hazard”problem.
The analog to this type of protection has been around for depository
institutions for over seventy years. The government has made an explicit
promise to make whole (most of) the depositors of thrifts and commercial banks through the Federal Deposit Insurance Corporation (FDIC).
In recognition of the moral hazard problem this insurance creates,
however, the government controls the risk-taking of these institutions
through regulation and prudential supervision. Thus, regulation has
been used to mitigate the moral hazard problem in the case of banks.
As we have come to witness during at least the past year-and-a-half,
however, the government safety net actually extends beyond the
regulated world of deposit-taking institutions. In fact, it now covers
parts of the lightly regulated world of non-banks. It is quite clear now
that market participants hold some expectation of government support
of large or highly-interconnected non-banks should an institution like
that face failure. Creating an SRR could turn the current implicit promise
of assistance to large and important firms into an explicit one.

an srr may EncouraGE moral hazard
By definition, a risk-curbing SRR would need broad powers and access
to taxpayer funds. The powers of the SRR would need to include
designating firms as “systemically important” and regulating them –
for instance, imposing more stringent capital and leverage ratio
requirements than those imposed on the firms not deemed systemically important. In addition, an SRR could be given a mandate to deal
with problems at firms designated as TBTF in order to avoid the threat
that failure of such an institution could pose to the stability of the
financial system as a whole. This mandate may include the power to
resolve the firm, put the firm in receivership or conservatorship, or
grant it taxpayer-funded loans, loan guarantees, or equity capital
Also, due in part to the fact that precise measurement of a nebulous
concept like “systemic risk”is not currently available or easy, the charter
of the SRR would need to allow a significant amount of discretion in
how the SRR deals with troubled financial institutions. This degree of
discretion may amplify the moral hazard problem.
How could this happen? If the charter of a new regulator puts a strong
emphasis on the SRR’s role in preventing a future financial crisis alongside the regulation of risk-taking, the failure of a large institution would
make the SRR look ineffective. It is probably a safe assumption that financial crises will occur in the future. Despite all its powers, the SRR is
not likely to be able to control perfectly the risk exposures of
important institutions – or, if it was able, it would drive the risky
activity to another corner of the financial market that would itself
then become systemically important.

Recognizing the moral hazard problem that the expansion of the federal
financial safety net creates for large non-banks, one could take a view
that these institutions should now be regulated more heavily too. In
this view, systemic risk provides an argument for why the government
should take on oversight of all financial institutions that are considered
too big or too important to be allowed to fail.

It is now clear how such an SRR could strongly encourage moral hazard
relative to today’s standards. The more likely the government is to extend support to a firm in a crisis instead of winding it down, the more
incentive the firm has to seek imprudent risk. This exacerbation of the
moral hazard problem makes the task of curbing risk-taking even more
difficult. And that, in turn, yields two possible results. It either makes
the probability of the occurrence of the next financial crisis not smaller
but larger – or it leads society to spend ever more resources to monitor
risk-taking by financial institutions.

Yet curbing risk-taking by not only banks but by all systemically important institutions is a task of enormous scale and complexity. If one looks
to more regulation as a critical element of the new regime of mitigating
systemic risk, one should carefully consider what might happen if
putting an air-tight seal on the economy's risk valve is simply too hard
to implement in practice.

Threats of new financial crises will always be with us. How we prepare
for them is an extremely complicated problem of great importance. In
this Economic Brief, we highlight one major aspect of the problem of
tasking a government agency with the power to intervene in markets to
manage a difficult-to-define notion called“systemic risk.”

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The complexity of government regulation of risk-taking by depository
institutions is dwarfed by the complex task of regulating risk-taking in
the economy as a whole. Creating government agencies charged with
controlling risk-taking everywhere in the economy can be dangerous.
Such agencies would need to have considerable power and discretion.
Yet that power and discretion can reinforce the moral hazard problem
resulting from the idea that some firms are too big to fail. This could increase, not decrease, the amount and concentration of risk in the financial system – and is an issue that should be given careful consideration
as policymakers debate the merits of adopting an SRR.

Borys Grochulski is an economist in the research department of
the Federal reserve Bank of richmond. stephen slivinski is
senior editor of the Bank’s quarterly magazine, Region Focus.

Financial Regulatory Reform – A New Foundation: Rebuilding Financial Supervision and Regulation.
Washington, DC: Department of the Treasury, June 17, 2009.

See gary H. Stern and Ron J. Feldman. Too Big to Fail: The Hazards of Bank Bailouts. Washington,
DC: Brookings Institution, 2004; and“The Role of the Safety Net in the Financial Crisis,”speech by
Jeffrey M. Lacker to the Asian Banker Summit, May 11, 2009.

The views expressed in this article are those of the authors and not
necessarily those of the Federal Reserve Bank of Richmond or the Federal
Reserve System.

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