April 15, 2009

Examining Systemic Risk

Margaret Polski

In September of 2008, Americans witnessed a domino effect involving the biggest financial institutions of our country. When Lehman Brothers declared bankruptcy and Merill Lynch was put under Bank of America's wing, Americans began to learn the interconnectedness of the banking system. For an industry that specializes in managing risk, how could bad decisions by a few banks jeopardize the entire system?

The risk that disturbances in one part of the system will spread to other parts and affect the entire system is known as systemic risk. Though the banking system has many sources of risk, systemic risk is difficult to manage due to the lack of transparency between banks. A bank will make a decision based on what is most beneficial for the company and may not take into account how that choice will impact the rest of the system. If that bank's decision causes it to become insolvent, the decision's effect will spread to other banks as a consequence of the claims they have on each other.

In the past few months Americans have seen a banking epidemic spread to Wall Street and Main Street, posing a high cost to our economy. Policy makers are seeking ways to regulate this systemic risk in hopes of preventing another downward spiral. To help better understand the aspects and consequences of systemic risk, the Mercatus Center hosts a lecture by Margaret Polski, an Affiliate Fellow at the Center for the Study of Neuroeconomics at George Mason University. Dr. Polski explores the sources of risk in modern banking and critically examine the proposal to create a "Systemic Risk Regulator".