Bank Systemic Risk Definitions Lack Transparency And Political Accountability; Require Ad Hoc Judgments Using Unreproducible And Bureaucratically Self-Serving Data; Incentivizes Banks To Increase Risk And Under Reserve For And Conceal Losses; Promotes Regulatory Arbitrage And Unconventional Central Bank Monetary Policies

From "Variation in Systemic Risk at US Banks During 1974-2010" by Armen Hovakimian, Edward J. Kane, and Luc Laeven, NBER Working Paper No. 18043, May 2012:

Definitions of systemic risk articulated by the Basel Committee and US policymakers lack the transparency needed to establish political accountability. Assessments based on these definitions turn on ad hoc judgments and confidential data that third parties cannot reliably replicate. The judgments in question combine subjective perceptions of individual-institution distress with projections of the ex ante potential for spillovers of individual defaults across a particular country's financial sector and from this sector to the national and global real economy.

This way of looking at systemic risk is not only unreproducible, it is logically incomplete, and can be bureaucratically self-serving. It excludes from the risk-generation process the channels through which financial safety-net management can mitigate or amplify financial stability. The existence of a safety net incentivizes banks to raise their risk profiles, underreserve for loss exposures, and to conceal actual losses (Kane, 1989; Demirguc-Kunt and Huizinga, 2004; Skinner, 2008; Huizinga and Laeven, 2011). Unless policymakers vigilantly and conscientiously address this incentive problem and the regulatory arbitrage it produces, aggressive firms will be tempted to abuse the financial safety net in clever ways.

Regulatory arbitrage is exemplified today by the growing use of unconventional monetary policies by central banks, including the provision of liquidity support against weak collateral. When hidden risk-taking goes sour, it can transform a firm’s riskiest exposures into political games of chicken whose outcome generates bailout expense for taxpayers. Because it is the path of least resistance, fiscal and monetary authorities tend to shift losses to taxpayers when deep or widespread insolvencies emerge (Honohan and Klingebiel, 2003; Veronesi and Zingales, 2010; Laeven and Valencia, 2011).

Authorities take refuge in the untested claim that it is in society’s best interest to minimize the possibility of contagious defaults. This hypothesis leads them to short-circuit the default process by characterizing firms that are politically, economically, or administratively difficult to fail and unwind (DFU)5 as “systemically important“ and supporting a DFU firm’s access to credit whenever difficulties in rolling over the firm’s liabilities suggests it may have to become economically insolvent. Until and unless sovereign credit support loses its credibility, authorities can prevent widespread substantial spillovers of actual defaults across the private financial sector from actually taking place.

© 2012 by Armen Hovakimian, Edward J. Kane, and Luc Laeven. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.