Systemic Risk: March 2011 Archives

No need to fear the shadows

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by Roy C. Smith

With the big banks under the boot of the regulators, tucked up with tougher capital ratios, trading restrictions and deferred incentives to rein in recklessness, some bank chief executives and academics have called for similar restrictions on the "non-bank monsters" of the shadow banking system where dangerous, unregulated risks are said still to reside.

A shadow banker is anyone who participates in the lending of money or its near equivalent. These would include financial intermediaries, off-balance-sheet investment vehicles and hedge funds, as well as institutional asset managers.

Altogether, global institutional investors managed about $150 trillion of securities and derivatives in 2009, compared with about $95 trillion for all banks.

But the idea that the next meltdown will occur in the widely distributed shadow banking sector is nonsense, now that its riskier aspects have been addressed.

The five systemically important US non-bank intermediaries - investment banks - were dissolved by the crisis: Lehman Brothers failed, large banks acquired Bear Stearns and Merrill Lynch, and Morgan Stanley and Goldman Sachs turned themselves into banks. The Federal Reserve now regulates them all.

Read the full opinion editorial on

Regulating Wall Street Co-Editor Ingo Walter presents a live webinar on March 31st at 12:00 pm ET titled "Inside Job: Reputational Risk and Conflicts of Interest in Banking and Finance"

Webinar Description: Banks, ratings agencies, insurance companies, policy makers and regulators are a few of the actors grappling with questions surrounding the balance between market discipline and market regulation in controlling conflicts of interest and reputational capital.

Professor Walter is the Vice Dean of the Faculty and Seymour Milstein Professor of Finance, Corporate Governance and Ethics at the Stern School of Business, New York University.

Professor Walter will talk about some managerial requisites for dealing with both reputational risk and conflicts of interest. The webinar aims to discuss:

  1. Sources of reputational risk facing financial services firms. 
  2. Link between reputational risk and exploitation of conflicts of interest in financial intermediation. 
  3. How to measure reputational losses.

This free hour-long webinar is presented for the Professional Risk Managers' International Association and is sponsored by NYU Stern's Master of Science in Risk Management for Executives.

Register to attend the webinar
by Jennifer Carpenter and Ingo Walter

Nothing about the financial crisis has done more to outrage the public and fuel reform than the drumbeat of bankers' pay announcements. Pay levels at Wall Street's top 25 banks reached a record high of $135bn last year, with employees' share of revenue rising to 32.5 per cent. While shareholders may have reason to object, the real concern for regulators and taxpayers on the hook for the next bail-out is not the level of pay, or how profits are divided between employees and shareholders, but rather the risk incentives that bank pay creates.

Reports of increased use of deferred compensation are cold comfort if it is in the form of stock, because as long as government guarantees are underpriced, the value of the stock increases with the bank's risk and leverage, so employees and shareholders are aligned in their incentives to ramp up risk. The Securities and Exchange Commission has just proposed to curb risk appetite by regulating bankers' compensation directly, requiring top executives at large banks to defer at least 50 per cent of incentive pay for three years. Regulators would do better to tackle the problem at its source, by setting deposit insurance premiums and taxes on other financial groups commensurate with the level of systemic risk they generate, and taking the risk appetite out of the equity itself.

Read the full opinion editorial in the Financial Times


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Even after a financial calamity, America's economic risk runneth over.

by Jim Tankersley

The windows of heaven opened over the Mississippi River basin in early April 1965, and rain was upon the land for half a month. It fell on soil hardened by an unusually deep winter frost and streams swollen with the melt from a heavy, late snow. On April 5, the Mississippi began rising rapidly in Minnesota, Wisconsin, and Iowa. Governors deployed the National Guard to build and patch dikes.

The river swept away houses or beat them to sticks, according to witness reports compiled by the National Weather Service. On April 16, Good Friday, surging waters broke through railroad tracks in Bluff Siding, Wis., and raced over thousands of acres of farmland, flinging dazed livestock across the countryside.

From north of Minneapolis down to Hannibal, Mo., the waters climbed to heights that still stand as records. The raging Mississippi inflicted what would be $1.5 billion in damages in today's dollars, a tab largely picked up by the federal government, because most of the farmers lacked flood insurance. It was a level of destruction that few townsfolk along the river had thought possible.

Read the full article on

Volcker May Get the Last Laugh

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by Roy C. Smith

The Dodd-Frank regulatory reform act in the US gives banks plenty of time to adjust to its Volcker Rule, the disallowance of proprietary trading.

The law itself provides them with lots of wiggle-room, with implementation left to the , which recently released a study it was required to make about the new rules.

Next, the FSOC will have to finalise the rules (expected in June) and circulate them for discussion and push-back from lobbyists. Then there will be a lengthy period allowed for the banks to put them into effect. It could all take years.

The FSOC study acknowledges that the distinction between "permissible" and "impermissible" trading may be difficult to make. Market-making, for example, is allowed under Dodd-Frank. This is defined by the banks as trading with or on behalf of clients.

The banks say there is no proprietary trading if any position held was acquired assisting a client. Also, virtually all trading today is financed in the market, through the repo or secured loan markets, so prop trading is hard to identify simply as being financed by a firm's own money.

Read the full opinion editorial on

Coming Out of the Shadows?

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by Viral Acharya

Regulators face difficult choices about how to regulate shadow banking.  There is much they might learn from the choices made by Depression-era governments.

Shadow banking is a system of financial institutions that mostly look like banks.  These highly leveraged institutions borrow in short-term debt markets and invest in longer-term illiquid assets.  This part of the financial system includes asset-backed commercial paper (ABCP), money market funds, securities lending and collaterialised repos (at broker-dealers).

The size of this market is roughly $800bn in the US alone (and even larger by some estimates) and matches the size of deposits, both insured and uninsured, held at depository institutions.  The growth of shadow banking over the past 25 years has been extraordinary relative to the growth of deposits.

Read the full piece from The Banker


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