Mitigating Systemic Risk: On Strategies against Synthetically Induced Risk in the Financial Sector
Abstract: Financial intermediaries have the incentive to attain the attribute “too big to fail” in order to externalize risk. As a consequence, the public has to shoulder the burden. This paper discusses mitigating systemic risk and the origin of this – what might be claimed – moral hazard, as well as the potential of ethics to counter these synthetically induced risks.
- Introduction
Financial intermediaries, such as global banks, have the incentive to externalize their exposure to risk by growing big, complex and interconnected in the entire financial system. By doing so, they urge governments and central banks to prevent a bank’s possible insolvency, since the institution’s insolvency and its contagious effects on the financial sector would cost more than the bailout by the government. Having this in mind, bankers integrate the probability of bailout in case of imminent insolvency into their risk analysis and, thus, externalize parts of the originally specialized banking risks to the government who acts involuntarily as an insurer. Further, due to the implicit insurance by the government, it might be argued that bankers are prone to take higher risks, as they do not have to integrate the risk of insolvency into their calculations. In economic literature, this mechanism is called the “too big to fail” doctrine.
As these incentives for banks clearly exploit the government, they are commonly seen as moral hazards in the literature. Thus, there is a recent argument on how to mitigate them. Considering advantages and disadvantages of big banks and of instability in the financial sector, a government or central bank has three options: Firstly, the concerned institution could not interfere at all and allow bankruptcies. This policy was the given standard before Walter Bagehot introduced the lender of last resort (hereafter referred to as LOLR) in response to the systemic crises that followed the insolvency of Overend & Guerney and Company in 1866. Secondly, the institution could consider Bagehot’s doctrine by granting bailouts only in cases of short-term illiquidity. The third option is to constantly bailout or to assure ex-ante a bailout when needed. In this case, the manifold possibilities of bailout have to be taken into consideration. For instance, both the nationalization of the bank of concern and the alteration of the law concerning insolvencies are bailout techniques.
Malte Nussberger studies Philosophy and Economics at the University of Bayreuth, Germany, and Financial Economics at EDHEC Business School in Nice, France, with a specific interest in systemic risk and governance. He has consulted on international projects in Germany and Egypt.
