Institutional Design and the New Systemic Risk in Banking Crises

Abstract

We argue that the concept of “systemic risk,” which traditionally focused on the relative stability of financial institutions and the consequences of their failure, has evolved to include macroprudential risk and the possibility that an entire economy will be affected by a triggering event or exogenous shock. As a result of this evolution, regulators have an important role to play in monitoring and managing systemic risk. We explore key policy instruments and the complement of domestic and international institutions that most effectively enable financial market regulators to discharge their role in monitoring and managing this new conception of systemic risk, which we refer to as the “new systemic risk” (NSR). We argue for more integration and co-ordination among institutions charged with systemic risk oversight and regulation, both domestically and internationally, recognizing that the existing set of institutions developed at a time when a more restricted conception of systemic risk prevailed. Specifically, we favour an approach to regulation under which financial markets are regulated according to certain regulatory objectives that are specified in the applicable legislation. Indeed, this approach identifies three basic regulatory objectives that the regulatory architecture must address: macro-economic stability typically associated with central banks in terms of implementing monetary policy and acting as lender of last resort in maintaining liquidity in the financial system; micro-prudential regulation which focuses on the financial stability of individual financial institutions; and conduct of business regulation designed to protect consumers of financial services and investors in financial institutions. We argue that this model benefits from coordination and cost advantages, while differentiating among objectives that are widely seen to require distinct regulatory strategies.