Stern: Regulators need to name names

Prominent economists at the Stern School of Business, New York University, today criticized Treasury Secretary Timothy Geithner and the new Financial Stability Oversight Council for failing to identify systemically risky firms, which the economists claim is the most important task the Dodd-Frank Act gave them.

It was somewhat disconcerting that Treasury Secretary Timothy Geithner, who is the Chairman of the Financial Stability Oversight Council, believes “creating effective, purely objective criteria for evaluating systemic risk is not possible.”

This simply isn’t true. And, the Council’s initial proposals miss what is the critical element in such risk assessment, which is the extent of correlation between the risk of a firm and the whole financial sector. Their primary focus on firm size and firm capital (based on current risk assessments) misses this entirely.

To prove their point, the Stern School has devised its own way to measure systemic risk, which it updates weekly. According to their calculations, Bank of America poses by far the most systemic risk to the U.S. financial markets. Runners-up are Citigroup, MetLife, J.P. Morgan, and American International Group.

They calculate the amount of systemic risk that each financial institution contributes to the financial markets by estimating the amount that a firm’s price stock would be expected to fall in a financial crisis and comparing that to the current market values of the company’s equity and debt.

Because it’s hard to measure debt accurately, with much leverage kept off the books in the shadow banking system, especially through netted repurchase transactions, the Stern analysts arrive at a leverage estimate by comparing the market value of the company’s assets to the market value of its equity, with some adjustments.

It’s important to identify the systemically dangerous companies because “After all, the market failure of the financial crisis was that firms created massive amounts of systemic risk without ‘paying’ for it,” say Stern professors Viral Acharya, Thomas F. Cooley, Robert Engle, and Matthew Richardson.

While the financial crisis started in the summer of 2007, it was not until the early autumn of 2008 that systemic risk fully emerged. Around this time, Fannie Mae, Freddie Mac, Lehman Brothers, AIG, Wachovia, Washington Mutual, and effectively Merrill Lynch and Citigroup, all failed. An important insight is that this risk was due not just to these failed financial firms, but also to other large banks, investment banks, and insurance companies that were struggling. In a financial crisis, it is the capital shortfall in the system as a whole that causes financial markets to freeze with devastating follow-on effects for the real economy.

And after the capital shortfall in late 2008, over the next 3-4 months, the economy fell off a cliff. Stock markets worldwide fell between 40%-50%, GDP dropped 3% in developed nations and international trade fell 10%. The link between the financial sector’s undercapitalisation and economic collapse is unmistakable. For that reason alone it is imperative to measure the build-up of systemic risk.