Systemic Risk and the Pursuit of Efficiency

Abstract

hat is systemic risk? When might it arise? How should it in- ‡uence policymakers? In this essay we identify systemic risk with the presence of linkages between market participants whereby problems for one directly create problems for others. We argue that such situations can arise from the use of contractual arrangements, especially debt that requires frequent re…nancing and liquidation in the event of an inability to repay. The presence of spillover eects can, in turn, lead to outcomes in the wake of shocks that can be unambiguously improved via policy intervention. Nonetheless, we caution against tak- ing this as a license to intervene after the fact, and instead suggest that observed contracting arrangements may be important in promoting ef- …cient trade between parties from a before the shockperspective. We argue that helping to ensure e¢ ciency as seen prior to a shock is the right goal for policymakers. Lastly, we note that the pursuit of such an objective may require credible commitments to tolerating ine¢ ciency after a shock. In the past two years, U.S. …nancial markets have undergone dra- matic changes, with storied …rms vanishing from existence and others surviving only as a direct result of public sector intervention. A handful of these events stand out as emblematic. These are, respectively, the bailouts of Bear Stearns, AIG, and the housing government-sponsored enterprises; the institution of large credit programs such as the Term Asset-Backed Securities Loan Facility (TALF) and the Troubled Asset Relief Program (TARP); and the striking nonbailout of Lehman Broth-