What is Systemic Risk?

More importantly, how will we measure it? Tomorrow, the president will unveil his regulatory reform framework in detail. The most important part of that reform, by far, will be exactly what new power he will give the Federal Reserve as systemic risk manager and what limits will be placed on that power.

That's because systemic risk is ultimately very subjective. We live in a globalized society and so the failure of one company can lead to the failure of others in a domino effect. How much of a domino effect must there be before it is "systemic"? Will this be subjective in the eyes of the Fed Chairman? So far, none of that is clear, and unless it is, this new role will lead to not only corruption but ultimately nothing more than an extension of monetary policy.

Think of it this way. With the Fed now the "systemic risk manager", it can determine that any financial institution is now too big to fail. It now is a "systemic risk". It can then determine that said company needs to carry more cash in reserves. If a bank takes money from its lending/investment portfolio and puts it in its vaults, isn't that the same thing as tightening monetary policy?

So, maybe the Fed is worried about inflation but doesn't necessarily want to raise rates to control it. Instead of what it would normally do, sell bonds, it tells say Goldman Sachs that Goldman needs another $50 billion in its reserves.

Look at the flip side. Let's say the Fed is worried we are about to head into a recession. Suddenly, it determines that Wells Fargo is no longer such a "systemic risk" and tells Wells that it can remove $50 billion from its vaults.

Will the Fed's new role as "systemic risk manager" be limited enough so that such abuses of power don't happen? We will see tomorrow but my money says no. That's because the president has never really defined exactly what those new powers are limited to. Regulators are there to keep businesses in line but rarely is there a mechanism to keep the regulator in line. In this case, the Regulator is also in charge of controlling the world's money supply. This is a dangerous combination and one I hope that the president has thought about. Something tells me he hasn't because he is increasing their power when he should be limiting it.

Furthermore, in reality, there's no need for a "systemic risk manager". We already have a mechanism for systemic risk, the Sherman Anti Trust Act. If a company poses a "systemic risk" it is inherently the definition of a monopoly.

Let's take an example. Let's look at AIG. Much of our problems could have been solved if the Feds had merely aggressively employed Sherman. After all, AIG was doing the overwhelming majority of underwriting CDS contracts. If one company dominates a market, in this case CDS underwriting, it is a monopoly. Had the feds broken up their CDS division early on, many of our problems wouldn't have happened.

Let's look at it another way. Sherman is supposed to limit monopolies and cartels. Well, with bank deregulation what came out was a set of mega financial services companies, Citigroup, Bear Stearns, Lehman, Goldman, etc. that had their fingers in every part of the system and thus essentially controlled the system. Isn't that what a cartel is? How could one company's failure cause a system wide failure if in fact the system was nothing more than a cartel? In fact, that's pretty much all it was. As such, any of these companies could have been broken up under Sherman.

So, why do we need a systemic risk manager when in fact we have a perfectly good law on the books to deal with this. It's because has gone out of style so to speak. It's been a long time since Teddy Roosevelt crused against trusts using Sherman as a hammer. So, now we need to create a new mechanism to resolve that which a perfectly good law was already created to resolve. Furthermore, Sherman would spread the power under multiple branches. Instead, we will allow an unelected financier another tool to control our money supply.