Regulating systemic risk

We argue that financial regulation be focused on limiting systemic risk, that is, the risk of a crisis in the financial sector and its spillover to the economy at large. To this end, we provide a simple and intuitive way to measure systemic risk in the financial sector and suggest novel regulations to limit it. Current financial regulations seek to limit each institution’s risk. Unless the external costs of systemic risk are internalized by each financial institution, the institution will have the incentive to take risks that are borne by all. In other words, each individual firm may take actions to prevent their own collapse but not necessarily the collapse of the system. It is in this sense that the financial institution’s risk is a negative externality on the system.2 An illustration of the current crisis is that financial institutions took bets on securities and portfolios of loans which faced almost no idiosyncratic risk, but large amounts of systematic risk.