NEW YORK – The near-complete collapse of financial systems worldwide has exposed fundamental weaknesses in their architecture and in how they are regulated. In calling for measures to “guard against systemic risk,” the G-20 summit has begun the process of reconstruction by recognizing that the system in its entirety, not just individual institutions, must be regulated.
Unfortunately, the G-20 communiqué offers only more of the same prescriptions for managing systemic risk that the Financial Stability Forum (FSF), the United States Federal Reserve, and others have put forward. These proposals have focused on the problems caused by poor transparency, over-leveraging, outsized financial institutions, tax havens, bad incentives for financial bosses, and credit rating agencies’ conflicts of interest. All of these are important, but they miss a fundamental point.
No one now denies that the past year’s sharp downswings in housing and equity prices, which followed long upswings – far above historical benchmark levels – helped to trigger and fuel the crisis. As these downswings continue, there is a danger that they, too, may become excessive, dragging the financial system and the economy even deeper into crisis.
Containing systemic risks, therefore, requires not just ensuring transparency and managing leverage in the system, but also recognizing that these risks vary along with asset values. If institutions that were heavily exposed had understood this, they would have raised their capital buffers during the run-up in housing and equity prices in order to protect themselves against the inevitable reversals. But, as we now know, they did not.