Earnest proclamations by politicians and regulators about systemic risk have been de rigueur since the 2007-09 global financial crisis. The 2010 Dodd-Frank Act created many new regulations and two new agencies to identify and act upon the alleged danger. The Office for Financial Research (OFR), housed at the U.S. Treasury, is supposed to collect and provide the data on potential systemic risks, and the Financial Stability Oversight Council (FSOC), chaired by the Secretary of the Treasury, is charged to act upon the information before they become a threat to financial stability.
“Not only has risky mortgage lending produced instability around the world, it also has crowded out more productive uses of funds.”
What drives systemic risk? One theory sees it as the result of "domino effects" arising within the banking system. If losses lead banks to de-lever and sell off risky assets, the sudden dumping of these assets could cause their prices to fall, endangering the solvency of other institutions. Furthermore, if banks are linked to each other via interbank debts, interest rate swaps, and insurance contracts, then the failure of one institution can potentially bring down others as the failed institution is unable to make good on its contractual agreements.
But as much academic research has shown, including an authoritative new book by Xavier Freixas, Luc Laeven, and Jose-Luis Peydro, Systemic Risk, Crises, and Macroprudential Regulation (MIT Press), these potential concerns have not proved to be the main problem. The primary source of trouble has been a combination of high leverage and undiversified risk-taking by banks and other intermediaries who rely on government-insured debt funding.
Two recent NBER working papers by Oscar Jorda, Moritz Schularick and Alan Taylor show that the majority of financial crises over the past several decades have been a consequence of the combination of the rising leverage of banks and their increasing concentration in real estate lending. It is not rocket science to understand that a financial system whose intermediaries use short-term debt to finance risky real-estate assets - assets with highly correlated risks, that move in sync with the business cycle, and which are hard to liquidate during times when prices fall -- is especially vulnerable to systemic insolvency.
Why would the market let banks structure themselves this way? It wouldn't, if the market was deciding on their structure. But it isn't...
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