Systemic Risk: March 2010 Archives

The Paradox of "Too Safe to Fail" Assets

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by Viral V Acharya and Arvind Krishnamurthy

While the House and the Senate Bills empower the regulators to impose greater capital requirements on banks and systemically important institutions, they provide little guidance on how we might have to improve design of capital requirements going forward. In particular, how should we deal with fail-safe assets such as AAA-rated tranches of mortgage-backed securities and liabilities such as overnight secured borrowing ("repos") which were not capitalized, were held in large quantities, and ended up bringing down the entire financial sector through losses and runs? The Financial Times oped at the link below (joint with Arvind Krishnamurthy) argues that the entire risk of these "too safe to fail" transactions is systemic in nature, and hence financial sector has incentives to essentially ignore the risk, unless we reform capital requirements to be higher for these transactions. This is in fact the opposite of how (Basel) capital requirements are currently designed, which is to in fact give higher incentives for such transactions.

Financial Times Market Insight column

Why bankers must bear the risk of "too safe to fail" assets.

March 18, 2010

http://www.ft.com/cms/s/0/9575ec0a-31e6-11df-a8d1-00144feabdc0.html

 

About RegulatingWallStreet.com

The Dodd-Frank Act, signed into law in July 2010, represented the most significant and controversial overhaul of the U.S. financial regulatory system since the Great Depression. Forty NYU Stern faculty, including editors Viral V. Acharya, Thomas F. Cooley, Matthew P. Richardson, and Ingo Walter, provide a definitive analysis of the Act, expose key flaws and propose solutions to inform the rules’ adoption by regulators, in a new book, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance (Wiley, November 2010).

About Restoring Financial Stability

Previously, many of these faculty developed 18 independent policy papers offering market-focused solutions to the financial crisis, which were published in a book, Restoring Financial Stability: How to Repair a Failed System (Wiley, March 2009).

About the Authors