Systemic credit risk vs systemic liquidity risk

Felix Salmon critiques a column by Lloyd Blankfein.  But he misses the real problem with the column:  Blankfein wants to perpetuate a system that failed.  “But the most critical question is what the systemic regulator should do, and what responsibilities will make it effective – not who, so much as how? …  the systemic regulator must be able to see all the risks to which an institution is exposed and require that all exposures be clearly recognised.”

Notice how anti-market this position is.  Blankfein places the responsibility for systemic risk squarely on the shoulders of regulators.  Most people who work in the financial sector, however, don’t seem to have much faith that regulators will ever manage to gain a sufficiently detailed understanding of what is actually going on in financial markets to regulate them effectively.  (This is also one of Felix Salmon’s criticisms.)  Thus Blankfein’s “solution” gives responsibility for systemic risk to people who are sure to fail.  In order for the Blankfein solution to work it must be the case that regulators are better able to manage systemic risk than markets — but Blankfein never gives us any explanation for why this would be the case.

One problem with debate over responsibility for systemic risk is that two very different forms of systemic risk are being confused.  Central banks have always taken responsibility for systemic liquidity risk because they have the ability (with the support of the government) to print money.  Thus if there is a liquidity problem central bankers are perfectly situated to solve it.

Systemic credit risk is a completely different issue.  Systemic crises of bad debts due to poor underwriting were unknown in the early years of central banking, because credit risk was the responsibility of the private sector.  This meant that underwriting standards were conservative, as bankers knew that bad debt would bankrupt them.  While individual firms collapsed due to poor underwriting, in the 19th century the standards of the financial sector as a whole did not.  Systemic credit risk is a problem that central bankers are poorly placed to supervise and control — it belongs in the hands of the managers of credit risk, and thus in the hands of the financial industry itself.

If responsibility for systemic credit risk is transferred to regulators, despite Blankfein’s optimism they are unlikely to ever have sufficient information to control that risk, and thus are sure to fail.  Of course, when they fail, they will create profitable situations for well-informed financiers — the profits that accrue from faulty regulation will come at the expense of either simple investors or taxpayers.  As I have said many, many times before the only solution to the current crisis is to keep the responsibility for systemic credit risk where it belongs — in the hands of the financiers, who are professional risk managers.

The only job of regulators and central banks, when a bank that has failed to manage risk collapses, is to provide enough liquidity to the financial system  to ensure that those banks that are  still solvent after the losses on the liabilities of the failed firm have been taken into account are not bankrupted by the illiquid markets resulting from the collapse.   When the regulators and the central bankers allow credit risk to be transferred on a long-term or permanent basis into the hands of the government, they undermine the foundations of the financial system, by underwriting the losses of the financiers.  Any attempt to address the “most critical question” generated by the crisis must take the fact that central banks are not responsible for systemic credit risk into account.

Note, however, that in my view given the system that was in place before the crisis, the transfers of taxpayer money to the financiers may have been a good move.  If — and only if — subsequent regulation puts the responsibility for systemic credit risk squarely in the hands of the private sector, then it will prove to have been the correct short-term policy.  If, however, the Blankfein’s of the world win the regulation debate and responsibility for systemic credit risk is transferred into the hands of the regulators, the bailout will just serve to make the next crisis worse.