Systemic risk

Georgetown Law Journal

Volumn 97, Issue 1, 2008, Pages 193-249

  Schwarcz, Steven L ^a  

^a DUKE UNIVERSITY   (United States)

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EID: 57149086909     PISSN: 00168092     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Review

References (453)

1. See, e.g., Systemic Risk: Examining Regulators' Ability To Respond to Threats to the Financial System: Hearing Before the H. Comm. on Financial Services, 110th Cong. (2007), available at http://www.house.gov/apps/ list/hearing/financialsvcs-dem)/htl002072.shtml (follow "Printed Hearing: 110-65" hyperlink) [hereinafter Systemic Risk Hearing]. References in this Article to "mortgage-backed securities" include not only traditional mortgage-backed securities but also collateralized-debt obligations securities backed by mortgage loans and "ABS CDO" securities backed by mortgage loans. For a detailed description of these types of securities and how they differ, see Steven L. Schwarcz, Protecting Financial Markets: Lessons from the Subprime Mortgage Meltdown, 93 MINN. L. REV. (forthcoming 2008).
2. See, e.g., Martin Crutsinger, Housing Construction Keeps Falling, HOUS. CHRON., Dec. 19, 2007, at 3 ("[T]he European Central Bank[] move[d] to inject money into the European banking system to combat the global credit crunch triggered by the meltdown in subprime mortgages in the United States.");
3. Sumeet Desai & Gemot Heller, G-7 To Weigh Global Response to Credit Crisis, REUTERS, Feb. 8, 2008, http://www.reuters.com/ article/politicsNews/idUST29356920080208 ("Financial leaders from the world's richest nations stood ready to discuss a global policy response to the [subprime mortgage] crisis, which has unleashed economic downdrafts and market turbulence that knows no borders.");
4. Matthew Saltmarsh, Europe Fears U.S. Slump, INT'L HERALD TRIB. (Paris), Dec. 5, 2007, at 12 ("In the strongest warning yet from a European Central Bank official that the 13-nation euro area is at risk from the U.S. subprime mortgage crisis, [Bank board member Christian Noyer] said optimism among consumers and executives was already deteriorating.");
5. Randal Smith et al., Loosening Up: How a Panicky Day Led the Fed To Act, WALL ST. J., Aug. 20, 2007, at Al;
6. Lauren Young, Bernanke's New Entourage, BUS. WK., Feb. 11, 2008, at 60 (discussing the Federal Reserve's concern over the subprime mortgage crisis and its potential systemic effect);
7. Robert A. Eisenbeis et al., An Analysis of Systemic Risks Posed by Fannie Mae and Freddie Mac and an Evaluation of the Policy Options for Reducing Those Risks 13 (Fed. Reserve of Atlanta, Working Paper 2006-2, 2006) (warning that the failure of Fannie Mae or Freddie Mac could create credit restraints having negative real effects on liquidity and the issuance of mortgages). Concern about systemic risk also has arisen in the insurance industry. The fear is that the collapse of an insurer or reinsurer could cause a chain reaction of collapses, depriving business of the insurance needed to operate. Buddy, Could You Spare Us $15 Billion?, ECONOMIST, Jan. 24, 2008, at 38 (reporting that in the aftermath of the subprime mortgage crisis insurers are increasingly at risk for being downgraded by ratings agencies, and that "from a systemic point of view, when a monoline [insurer] is downgraded all of the paper it had insured must be downgraded too");
8. cf. Chris Mundy, The Nature of Systemic Risk: Trying To Achieve a Definition, BALANCE SHEET, Oct. 24, 2004, at 30 (discussing that post-9/11-"the insurance industry's biggest ever disaster"-the aviation insurance industry temporarily had to reduce insurance coverage below the level at which airlines could, according to their loan covenants and regulatory restrictions, continue to operate and that governments had to intervene to provide coverage).
9. See, e.g., Edmund L. Andrews, Fed Acts To Rescue Financial Markets, N.Y. TIMES, Mar. 17, 2008, at Al;
10. Andrew Ross Sorkin, JP Morgan Pays $2 a Share for Bear Stearns, N.Y. TIMES, Mar. 17, 2008, at Al;
11. Landon Thomas, Jr., Fears that Bear Stearns's Downfall May Spread, N.Y TIMES, Mar. 17, 2008, at CI (quoting Treasury Secretary Henry Paulson as being less concerned at the moment about moral hazard than about the stability of the financial system).
12. A hedge fund is, essentially, a private and unregistered investment vehicle. Registration Under the Advisers Act of Certain Hedge Fund Advisers, 69 Fed. Reg. 72,054, 72,055 (Dec. 10, 2004) (to be codified at 17 C.F.R. pts. 275, 279). In today's market environment, hedge funds commonly take investor "equity" money and also borrow money to make market bets, including leveraged bets (through derivatives) on market movements. From the standpoint of investors, the goal of hedge funds is to achieve high rates of return. From the standpoint of hedge-fund managers, the goal is to earn substantial management fees. Hedge funds are estimated to have assets exceeding a trillion dollars. See Troy A. Paredes, On the Decision To Regulate Hedge Funds: The SEC's Regulatory Philosophy, Style, and Mission, 2006 U. ILL. L. REV. 975, 981-82.
13. See infra notes 35-40 and accompanying text.
14. See, e.g., PRESIDENT'S WORKING GROUP ON FIN. MKTS., HEDGE FUNDS, LEVERAGE, AND THE LESSONS OF LONG TERM CAPITAL MANAGEMENT 31-32 (1999) [hereinafter PRESIDENT'S WORKING GROUP] (recommending measures to restrain excessive leverage of hedge funds);
15. STAFF REPORT TO THE U.S. SEC, IMPLICATION TO THE GROWTH OF HEDGE FUNDS 89 (2003) (recommending that the SEC amend Rule 203(b)(3)-1 to redefine "client" such that most hedge funds would require registration with the SEC);
16. U.S. GEN. ACCOUNTING OFFICE, LONG TERM CAPITAL MANAGEMENT: REGULATORS NEED TO FOCUS GREATER ATTENTION ON SYSTEMIC RISK 14-15 (1998) (discussing the concern of regulators for the potential risks posed by hedge funds during a period of declining credit standards);
17. Anthony W. Ryan, Assistant Sec'y for Fin. Mkts., U.S. Dep't of the Treasury, Remarks Before the Managed Funds Association Conference (June 11, 2007) (transcript on file with author);
18. see also Ben S. Bernanke, Chairman, Bd. of Governors, U.S. Fed. Reserve Sys., Remarks at the Federal Reserve Bank of Atlanta's 2006 Financial Markets Conference, Sea Island, Georgia (May 16, 2006), available at http://www.federalreserve.gov/Boarddocs/speeches/2006/200605162/default.htm (offering thoughts on the systemic risk implications of the rapid growth of the hedge fund industry and on ways that policymakers might respond to those risks);
19. Comments by Richard Blumenthal, Att'y Gen. of Conn., The Diane Rehm Show, National Public Radio, May 9, 2007 (arguing that hedge funds should be regulated to avoid systemic risk).
20. See John Gieve, Deputy Governor, Bank of Eng., Speech at the Centre for the Study of Financial Innovation Roundtable: Financial System Risks in the UK-Issues and Challenges (July 25, 2006) (observing the shift away from bank-dominated finance); Andre Icard, Deputy Manager, Bank for Int'l Settlements [BIS], Risk Measurement and Systemic Risk, Speech at the Fourth Joint Central Bank Research Conference on Risk Management and Systemic Risk (Nov. 8,2005), available at www.bis.org/http://www.bis.org/speeches/sp051108.htm (discussing the "evolution of systemic risk" to include interdependencies among banks, financial markets, and market infrastructure);
21. Yutaka Yamaguchi, Deputy Governor, Bank of Japan and Chairman of the Comm. on the Global Fin. Sys., Triangular View of Systemic Risk and Central Bank Responsibility, Speech for the Third Conference on Risk Measurement and Systemic Risk, Bank for Int'l Settlements 2 (Mar. 7, 2002), available at http://www.bis.org/cgfs/conf/mar02h.pdf (warning that in order to understand systemic risk, one must investigate the nexus among the banking system, financial markets, and the real economy);
22. cf. Gabriel Kolko, Weapons of Mass Financial Destruction, LE MONDE DIPLOMATIQUE (Eng.), Oct. 2006, at 1,2, available at http://mondediplo.com/2006/10/02finance (observing that the IMF is concerned that bank deregulation has allowed financial systems to become more vulnerable to systemic risk and to a growing number of financial crises);
23. Henry Paulson, Sec'y, U.S. Dep't of the Treasury, Remarks on Recommendations from the President's Working Group on Financial Markets (Mar. 13, 2008), available at http://www.ustreas.gov/press/releases/hp872.htm (focusing on a similar concern among markets in addition to banks).
24. OXFORD ENGLISH DICTIONARY 499 (2d ed. 1989).
25. George G. Kaufman, Bank Failures, Systemic Risk, and Bank Regulation, 16 CATO J. 17, 21 n.5 (1996) (quoting Alan Greenspan, Remarks at a Conference on Risk Measurement and Systemic Risk, Board of Governors of the Federal Reserve System (Nov. 16, 1995)), available at http://www.cato.org/pubs/journal/cj16n-2.html.
26. Id.
27. Id. at 20. Kaufman points out that this definition is consistent with that of other leaders in the banking and regulatory field. For example, the Bank for International Settlements (BIS) has defined systemic risk as the "risk that the failure of a participant to meet its contractual obligations may in turn cause other participants to default."
28. Id. at 21 n.5. The head of the San Francisco Federal Reserve Bank has defined it as the "risk that one bank's default may cause a chain reaction of . . . failures and even threaten the solvency of institutions." Id.
29. Paul Kupiec & David Nickerson, Assessing Systemic Risk Exposure from Banks and GSEs Under Alternative Approaches to Capital Regulation, 48 J. REAL EST. FIN. & ECON. 123, 123 (2004) ("[A] key feature in the propagation of such a systemic shock is acute uncertainty regarding an institution's ability to satisfy its immediate payment obligations and a simultaneous inability of counterparties to hedge such risk.").
30. This is the definition favored by the U.S. Commodity Futures Trading Commission. See U.S. Commodity Futures Trading Comm'n, CFTC Glossary, http://www.cftc.gov/educationcenter/glossary/glossary-s.html (last visited May 13, 2008);
31. cf. Nicholas Chan et al., Systemic Risk and Hedge Funds 1 (MIT Sloan Sch. of Mgmt., Working Paper No. 4535-05, 2005), available at http:/ssrn.com/ abstact=671443 (defining systemic risk as "the possibility of a series of correlated defaults among financial institutions-typically banks-that occurs over a short period of time, often caused by a single major event").
32. The third definition focuses solely on repercussions to market participants.
33. The classic example of a tragedy of the commons is an overgrazed pasture resulting from common ownership so that no individual owner has the right to exclude use by other owners. See Garret Hardin, The Tragedy of the Commons, 162 SCIENCE 1243, 1244 (1968). The original concept of a tragedy of the commons can be traced back to Aristotle. ARISTOTLE, POLITICS 57 (Benjamin Jowett trans., Courier Dover 2000) ("[T]hat which is common to the greatest number has the least care bestowed upon it. Every one thinks chiefly of his own, hardly at all of the common interest.").
34. Tragedies of the commons sometimes can be addressed by regulators informally pressuring parties to work collectively. See Armin Falk et al., Appropriating the Commons: A Theoretical Explanation, in THE DRAMA OF THE COMMONS 158 (Elinor Ostrom et al. eds., 2002). For a discussion of the market discipline approach and why it is insufficient, see infra notes 245-61 and accompanying text.
35. See infra notes 65-68 and accompanying text.
36. William J. McDonough, President, Fed. Reserve Bank of N.Y., Statement Before the United States House of Representatives Committee on Banking and Financial Services (Oct. 1, 1998), in FED. RES. BULL., Dec. 1998, available at http://newyorkfed.org/newsevents/ speeches/1998/mcd981001.html (stating that the most important direct consequence of systemic risk brought on by a failure of Long-Term Capital Management would have been "increases in the cost of capital to American businesses");
37. see also E.P. DAVIS, DEBT, FINANCIAL FRAGILITY, AND SYSTEMIC RISK 117 (1992) (describing the worst consequence of systemic risk as "disrupt[ing] the payments mechanism and capacity of the system to allocate capital").
38. Mundy, supra note 2, at 29.
39. R.W. HAFER, THE FEDERAL RESERVE SYSTEM 145 (2005) (observing that a bank's cash reserves are often less than five percent of its deposits).
40. Kaufman, supra note 9, at 20;
41. see also Jürgen Eichberger & Martin Summer, Bank Capital, Liquidity and Systemic Risk 14 (Oesterreichische Nationalbank, Working Paper No. 87, 2004).
42. Kaufman, supra note 9, at 20-21;
43. see also Icard, supra note 7 (discussing how disturbances could arise and spread within the banking sector).
44. Michael D. Bordo et al., Real Versus Pseudo-International Systemic Risk: Some Lessons from History 21 (Nat'l Bureau of Econ. Research, Working Paper No. 5371, 1995).
45. Id. To some extent, this was in order to obtain funds to satisfy margin calls, and to some extent this was simply in panic.
46. Id.
47. Id.;
48. Gary Richardson, Bank Distress During the Great Contraction, 1929 to 1933, New Data from the Archives of the Board of Governors 24 (Nat'l Bureau of Econ. Research, Working Paper No. 12590, 2006) (concluding that between one-third and one-half of bank failures were due to contagion and illiquidity chains). But cf. Charles W. Calomiris & Joseph R. Mason, Causes of U.S. Bank Distress During the Depression 32-33 (Nat'l Bureau of Econ. Research, Working Paper No. 7919, 2000) (arguing that most banks failed during the Great Depression for endogenous reasons and not because of financial intertwining).
49. Bordo et al., supra note 23, at 21.
50. FREDERIC S. MISHKIN, THE ECONOMICS OF MONEY, BANKING, AND FINANCIAL MARKETS 261 (7th ed. 2006).
51. Steven L. Schwarcz, Enron and the Use and Abuse of Special Purpose Entities in Corporate Structures, 70 U. CIN. L. REV. 1309, 1315 (2002). Capital markets are now the nation's and the world's most important sources of investment financing.
52. See, e.g., MCKINSEY GLOBAL INST., MAPPING THE GLOBAL CAPITAL MARKET: THIRD ANNUAL REPORT 7 (2007), available at http://www.mckinsey.com/mgi/pubhcations/third-annual-report/ index.asp (reporting that as of the end of 2005, the value of total global financial assets, including equities, government and corporate debt securities, and bank deposits, was $140 trillion).
53. Cf. Bordo et al., supra note 23, at 4 ("[R]ecent literature is less concerned than it was in earlier times with contagious banking panics as the key source of systemic risk.").
54. WESLEY B. TRUITT, THE CORPORATION 107-09 (2006). Firms often use capital markets to turn illiquid assets into cash. For instance, through securitization, banks can turn long-term mortgages into easily tradable securities.
55. MEIR KOHN, FINANCIAL INSTITUTIONS AND MARKETS 381 (2d ed. 2004). Firms can also borrow more cheaply through bonds and commercial paper than they can from banks.
56. See id. at 145 .
57. Yamaguchi, supra note 7, at 1. Yamaguchi, the former Deputy Governor of the Bank of Japan, warns that financial markets now play a role as sources of systemic disturbances. Id.
58. Icard, supra note 7.
59. RICHARD A. POSNER, ECONOMIC ANALYSIS OF LAW 446 (6th ed. 2003).
60. Id. (arguing that risk that is positively correlated with the market itself cannot be diversified away). Judge Posner implicitly assumes, of course, that the market risk at issue cannot be diversified away by investing in unlinked diverse markets.
61. ROGER LOWENSTEIN, WHEN GENIUS FAILED: THE RISE AND FALL OF LONG-TERM CAPITAL MANAGEMENT 144-46, 164,169-70 (2000).
62. McDonough, supra note 18 (describing ways that the problems of LTCM could have caused more widespread financial troubles).
63. See id. (concluding that the most important consequence of systemic risk brought on by a failure of LTCM would have been increasing the cost of capital).
64. See supra note 21 and accompanying text.
65. A derivative is a contract under which the parties agree to exchange payments calculated by reference to the price of a commodity or financial instrument, a rate, index, or some other economic measurement. See CHRISTIAN A. JOHNSON, A GUIDE TO USING AND NEGOTIATING OTC DERIVATIVES DOCUMENTATION 1 (2005).
66. Cf. PRESIDENT'S WORKING GROUP, supra note 6, at 23 (observing that the indirect impact on markets of the failure of individual market participants is potentially more serious than such failure itself: "[v]olatility and sharp declines in asset prices can heighten uncertainty about credit risk and disrupt the intermediation of credit," which in turn "could cause a contraction of credit and liquidity, and ultimately, heighten the risk of a contraction in real economic activity");
67. see also supra notes 37-40 and accompanying text.
68. Although the above paragraph focuses on systemic risk resulting from hedge-fund failure, hedge funds might indirectly contribute to bank systemic risk insofar as hedge-fund lack of regulation enables them to make relatively risky investments, including risky loans. This may be forcing banks to make loans without financial covenants in order to compete. Interview with Douglas Rosefsky, Managing Director, Alvarez & Marsal, in Durham, N.C. (Mar. 21, 2007). This dilemma, however, does not arise out of the nature of hedge funds qua hedge funds but, rather, out of their unregulated nature, enabling them to make risky investments if they choose to do so. Moreover, it is questionable whether making loans without financial covenants (sometimes called "covenant-lite loans") even constitutes "safe and sound" banking practice. Cf. JOËL BESSIS, RISK MANAGEMENT IN BANKING 514 (2d ed. 2002) ("Covenants become essential whenever the credit standing of the borrower and/or the collateral do not provide adequate protection.");
69. Grover R. Castle, Term Lending-A Guide to Negotiating Term Loan Covenants and Other Financial Restrictions, J. COM. BANK LENDING, Nov. 1980, at 26, 30-39 (tables showing that most bank loans contain financial covenants);
70. Jyrki Niskanen & Mervi Niskanen, Covenants and Small Business Lending: The Finnish Case, 23 SMALL BUS. ECON. 137, 137 (2004) (observing that the norm in bank loan agreements in the United States is to include covenants).
71. But compare infra notes 48-51 and accompanying text for a discussion of why hedge funds, as operated in today's market environment, may pose greater risk potential than other types of business organizations.
72. There is, however, dissent within the SEC over whether the "retailization" of hedge funds is increasingly exposing ordinary people to hedge-fund risk. Amie Filipchuk, Development in Banking and Financial Law: 2004-Securities: The Securities and Exchange Commission's Registration Requirement for Hedge Fund Advisers, 24 ANN. REV. BANKING & FIN. L. 189, 191,193-95 (2005).
73. Section 4(2) of the Securities Act, 15 U.S.C. § 77d(2) (2004), exempts from the registration-statement and prospectus requirements of section 5 of that Act "transactions by an issuer not involving any public offering." This exemption has been interpreted to include a variety of different transactions where-taking into account the number of offerees, their relationship to each other and to the issuer, the number of units offered, and the manner of the offering-the SEC considers there is little benefit or no practical need for regulation. See L. LOSS & J. SEUGMAN, FUNDAMENTALS OF SECURITIES REGULATION 395 (5th ed. 2004).
74. For a description of LTCM's billions of dollars of exposure, see supra notes 36-37 and accompanying text; see also PRESIDENT'S WORKING GROUP, supra note 6, at 2 (comparing hedge funds to "other large highly leveraged financial institutions" in terms of their "potential to disrupt the functioning of financial markets");
75. Roger Ferguson & David Laster, Hedge Funds and Systemic Risk, FIN. STABILITY REV., Apr. 2007, at 45, 51 (arguing that the failure of Amaranth, unlike the case of LTCM, "posed little systemic risk because [the losses] occurred in a relatively small and isolated market").
76. This "size matters" observation would apply not only to a single large hedge fund, but also to multiple, collectively large hedge funds adopting a similar investment strategy ("convergence"). Cf. Anthony Murphy, Managing Director, Citi Markets and Banking, Understanding Derivatives: Dissecting Complex Financial Instruments, Remarks at the International Insolvency Institute's Seventh Annual Conference (June 12, 2007) (on file with author).
77. Also, sometimes poor management controls can make hedge funds more "fragile" than other institutions. Cf. PRESIDENT'S WORKING GROUP, supra note 6, at 5 (observing that hedge funds sometimes take on "structured or illiquid positions whose full value cannot be realized in a quick sale," which can "potentially make them somewhat fragile institutions" compared to other trading institutions because they are more "vulnerable to liquidity shocks"). Even though banks and securities firms sometimes take similar illiquid positions, "these organizations and their parent firms often have both liquidity sources
78. and independent streams of income from other activities that can offset the riskiness of their positions." Id.
79. See supra note 47.
80. See supra note 4.
81. See, e.g., Francesco Guerrera & James Politi, Moody's Threat on 'Aggressive' Buy-outs, FIN. TIMES, Jan. 15, 2008, at 1 (discussing many buy-out firms' converging propensity to take "dividend 'recaps," which are "controversial because they allow private equity owners to extract profits quickly and eliminate risk from a deal, while often leaving portfolio companies in a more precarious financial position").
82. For a discussion regarding why increases in the cost of capital or decreases in its availability are the main consequences of systemic risk, see supra note 18 and accompanying text.
83. Campbell R. Harvey's Hypertextual Finance Glossary [hereinafter Finance Glossary], http://www.duke.edu/%7Fxharvey/Classes/wpg/bfgloss.htm#systematic- risk;
84. see also Bordo et al., supra note 23, at 8 (referring to this as the "financial fragility" approach). In an expanding market, for example, optimism accelerates as investors reach a state of over-indebtedness, followed by "insufficient cash flow[s] to service their liabilities." Distressed selling may then occur. These inevitable market fluctuations appear to be systematic, not systemic, although they sometimes might trigger systemic problems. See Bordo et al., supra note 23, at 9.
85. But cf. id. at 10 (discussing how normal market expansions and contractions can turn into market crises in situations of "speculative mania").
86. By the same token, politics should not impede attempts to reach realistic solutions to the problem of real systemic risk. In the present subprime mortgage crisis, for example, the author has seen many examples of "bottom-up" attempted political fixes, protecting homeowners who allegedly have been taken advantage of by "predatory" mortgage lenders. These approaches focus on micromanaging the loan terms and foreclosure process for, potentially, millions of defaulting mortgagors. For instance, the Federal Housing Administration has been helping individual borrowers refinance their mortgages. Brad Finkelstein, Securing Your Borrowers:
87. The FHA Secure Program Is Good News for Originators and Consumers, BROKER, Jan. 2008, at 32-34. In contrast, this Article's recommendation-to create a "liquidity-provider of last resort" to fund illiquid financial markets,
88. see infra section II.D-is more of a top-down approach. It does not focus directly on individual homeowners, and therefore is not as politically acceptable. Nonetheless, such a top-down approach, by restoring financial-market confidence, would increase the availability of home mortgages, causing home prices to rise and thereby greatly reducing mortgagor defaults.
89. Although scholars also view regulation through public choice theory, that is not a normative goal but, rather, a descriptive explanation of what actually occurs. "Public choice theory views regulation as the outcome of the efforts of interest groups, politicians, and bureaucrats to use the political process for their own personal benefit," generating regulations in the absence of market failures. RICHARD J. HERRING & ROBERT E. LITAN, FINANCIAL REGULATION IN THE GLOBAL ECONOMY 82-83 (1995).
90. See W. KIP VISCUSI, JOHN M. VERNON, & JOSEPH E. HARRINGTON, JR., ECONOMICS OF REGULATION AND ANTITRUST 9 (3d ed. 2000) (arguing that, where health and safety are not at issue, the rationale for regulatory policy is "foster[ing] improvements judged in efficiency terms");
91. Gillian K. Hadfield, Privatizing Commercial Law: Lessons from the Middle and the Digital Ages 58 (Stanford Law Sch., John M. Olin Program on Law and Econ., Working Paper No. 195, 2000), available at http://papers.ssrn.com/sol3/papers.cfm?abstract-id=220252 ("The public value at stake in relationships between commercial entities . . . is economic efficiency.").
92. See THOMAS LEE HAZEN, THE LAW OF SECURITIES REGULATION 9 (3d ed. 1996); see also GEORGE J. STIGLER, THE CITIZEN AND THE STATE 88 (1975) (arguing that economic efficiency should be the central goal of U.S. securities laws because "efficient capital markets are the major protection of investors"); John C. Coffee, Jr., Market Failure and the Economic Case for a Mandatory Disclosure System, 70 VA. L. REV. 717, 751-52 (1984) (claiming that "the strongest arguments for the mandatory disclosure system" under securities law may be based on efficiency). Although some have suggested that fairness is also an important goal of securities regulation, fairness might only be relevant in this context as a means of achieving efficiency.
93. See, e.g., The Bond Price Competition Improvement Act of 1999: Hearing on H.R. 1400 Before the Subcomm. on Finance and Hazardous Materials of the H. Comm. on Commerce, 106th Cong. 9 (1999) (statement of Hon. Arthur Levitt, Chairman, SEC) ("Informed investors, armed with accurate information, ensure that market prices represent fair values. And fair market prices, in turn, ensure that the markets perform their economic function of efficiently allocating capital resources.").
94. Cf. HAL S. SCOTT & PHILIP A. WELLONS, INTERNATIONAL FINANCE 46 (7th ed. 2000) (claiming that securities law provides an opportunity to "develop a global regulatory framework that preserves the efficiencies associated with international capital mobility").
95. HENDRIK S. HOUTHAKKER & PETER J. WILLIAMSON, THE ECONOMICS OF FINANCIAL MARKETS 285 (1996).
96. See HERRING & LITAN, supra note 56, at 79-80.
97. See DAVID GOWLAND, THE REGULATION OF FINANCIAL MARKETS IN THE 1990s 21 (1990). Regulating markets to correct market failure is sometimes referred to as the "public interest theory." Id.
98. See PRESIDENT'S WORKING GROUP, supra note 6, at 31.
99. See RODRIGO Cifuentes et al., Liquidity Risk and Contagion 17-18 (Bank of Eng., Working Paper No. 264, 2004), available at http://papers.ssrn.com/sol3/papers.cfm?abstract-id=824166 ("[W]hen choosing their portfolio allocation banks do not internalise the positive externalities that holding more liquidity has on the stability of the system. Therefore, the privately determined liquidity will be suboptimal.").
100. For a discussion of the social impact of a systemic collapse of the financial system, see infra note 70 and accompanying text.
101. Hardin, supra note 15, at 1244-45.
102. In other words, individual market participants may choose to act selfishly because their returns are assured, whereas a systemic collapse is not necessarily inevitable. LTCM, for instance, knew there was a risk of failure if the markets became irrational, but chose to trust models that made it money. See LOWENSTEIN, supra note 36, at 71-75, 173.
103. Cf. Cifuentes et al., supra note 64, at 20 (observing that because banks do not internalize externalities regarding financial-system stability, "liquidity and capital requirements . . . need to be externally imposed"). The need for regulation must be balanced, of course, by its cost. The extent to which the benefits of systemic-risk regulation exceed its costs, and the extent to which such regulation is more cost-effective when implemented on an ex ante preventative or ex post reactive basis, is discussed infra sections II.C and II.D.
104. I thank my colleague, Ralf Michaels, for this insight into differentiating risks within, and to, the financial system.
105. The widespread poverty and unemployment caused by the Great Depression, for example, apparently fostered a significant increase in crime. See Jeffrey L. Kirchmeier, Another Place Beyond Here: The Death Penalty Moratorium Movement in the United States, 73 U. COLO. L. REV. 1, 11 (2002) (discussing an explosion of executions as probably resulting from increased crime due to the Great Depression);
106. cf. Erin Ryan, Federalism and the Tug of War Within: Seeking Checks and Balance in the Interjurisdictional Gray Area, 66 MD. L. REV. 503, 636-37 (2007) ("[P]ragmatism . . . seems well-suited to the circumstances of the time: massive unemployment, farmer uprisings and hunger marches, public rioting, and widespread fear of revolt.").
107. VISCUSI ET AL., supra note 57, at 9.
108. See U.S. DEP'T OF HOMELAND SEC., PANDEMIC INFLUENZA: PREPAREDNESS, RESPONSE, AND RECOVERY- GUIDE FOR CRITICAL INFRASTRUCTURE AND KEY RESOURCES (2006), available at http://www.pandemicflu.gov/plan/pdf/CIKRpandemicInfluenzaGuide.pdf.
109. Critical industry sectors are broken down into critical infrastructure and key resources. Critical infrastructure is defined as "systems and assets . . . so vital to the United States that [their] incapacity or destruction . . . would have a debilitating impact on security, national economic security, national public health or safety, or any combination of those matters." Id. at 20. Critical infrastructure includes thirteen sectors: banking and finance, food and agriculture, national monuments and icons, chemical and hazardous materials, defense industrial base, water, public health and healthcare, energy, emergency services, information technology, telecommunications, postal and shipping, and transportation. Id. at 7. Key resources include: commercial facilities, government facilities, dams, and nuclear power plants. Id.
110. Id. at 20. DHS is concerned that a pandemic, by disturbing these industry sectors, might cause "economic disruption" and "social disturbance." Id. at 28.
111. This is not to say that preserving the financial system will always be socially optimal. An iconoclast might contend that a collapse of the financial system could, in the long run, sometimes be beneficial for society, such as by redistributing wealth (although there is no assurance how wealth would be redistributed, and it is likely that overall wealth would be much diminished). Even the Great Depression arguably resulted in some desirable changes, such as social security, that might not otherwise have been politically feasible.
112. But see Milton Friedman, Social Security Chimeras, N.Y. TIMES, Jan. 11, 1999, at A17 (finding it "hard to justify requiring 100 percent of the people to adopt a Government-prescribed [social security] straitjacket").
113. Another way to view stability as a goal of systemic-risk regulation derives from the recognition that, in matters of health and safety, increasing social well-being and not economic efficiency alone is generally understood to be the goal of regulation. Because it is difficult to identify non-efficiency goals for traditional financial regulation,
114. see Steven L. Schwarcz, Private Ordering, 97 NW. U. L. REV. 319, 331-32 (2002), it might seem that any ultimate inquiry into consequences would require empirical testing and, to some extent, may be more of a political than a legal determination. In the case of systemic risk, however, the answer may be more straightforward: the non-efficiency goals should be those needed to prevent systemic risk's devastating consequences to health and safety. It is these consequences, not the inherent nature of systemic risk per se, that makes the question of regulating systemic risk most important.
115. Cf. RICHARD A. POSNER, LAW,
116. Yamaguchi, supra note 7, at 2-3 (considering the importance of consequences in the context of strategic interactions and central banks). These consequences can be prevented, however, by preventing the collapse of the financial system.
117. Although I recognize that efficiency, in a broad sense, includes not only health and safety, see supra note 71 and accompanying text, but also stability, it will be analytically useful to view stability as separate from efficiency per se.
118. See, e.g., JOHN EATWELL & LANCE TAYLOR, GLOBAL FINANCE AT RISK 19 (2000) ("[Regulation can be expensive and oppressive or even downright wrongheaded. Overly fastidious regulation may result in risks being overpriced, and hence will stifle enterprise . . . . A balance needs to be struck . . . .");
119. see also EDITH STOKEY & RICHARD ZECKHAUSER, A PRIMER FOR POLICY ANALYSIS 309-10 (1978) ("[T]he history of [government] interventions to deal with market failure is a history of disappointmentsf, and hence one] should recognize that market failure does not mandate government intervention; it just suggests the possibility that such intervention might prove beneficial.");
120. cf. Steven L. Schwarcz, The Easy Case for the Priority of Secured Claims in Bankruptcy, 47 DUKE L.J. 425, 475 n.225 (1997) (discussing the ability of market participants, in this case lenders, to find alternative markets, but that in the case of systemic risk, shifting investments to foreign markets (capital flight) would harm the domestic economy). Regulation also can be misguided or counterproductive, sometimes even conflating cause and effect.
121. Cf. POSNER, SUPRA note 34, at 457 (observing that securities market regulation is "founded on the premise that without such regulation [such markets] would not function satisfactorily," but then arguing that this premise "is rooted in part in a misconception about the great depression of the 1930s"-the misconception being the natural tendency to think of the 1929 stock market crash as resulting from abuses and, in turn, being a cause of the depression, whereas a precipitous decline in stock prices is more likely to result from the expectation of a decline in economic activity).
122. Even where there is market failure, "government intervention may not [always] yield a superior outcome." VISCUSI ET AL., supra note 57, at 10; see also id. at 13 ("[G]overnment failure' may be of the same order of importance as market failure.").
123. See, e.g., David T. Llewellyn, Competition and the Regulatory Mix, NAT'L WESTMINSTER BANK Q. REV., Aug. 1987, at 4-5;
124. see also EATWELL & TAYLOR, supra note 78, at 19 (observing that overly fastidious regulation may result in risks being overpriced).
125. See Charles G. Hallinan, The "Fresh Start" Policy in Consumer Bankruptcy: A Historical Inventory and an Interpretive Theory, 21 U. RICH. L. REV. 49, 84 (1986) (relying on the economic definition of moral hazard: debtors and creditors that are protected from the consequences of default "could be expected to increase both excessive borrowing and excessive resort to bankruptcy"). In the insurance context, in which the term "moral hazard" arose, it means "the deliberate efforts by the insured to bring about the insured event, as when the owner of life insurance commits suicide." Richard A. Epstein, Products Liability as an Insurance Market, 14 J. LEGAL STUD. 645, 653 (1985).
126. See GOWLAND, supra note 62, at 21.
127. In a non-financial context, an example would be government aid (somewhat analogous to bailout loans) to flood-plain homeowners that encourages those homeowners to rebuild in the flood plain.
128. See Robert McLeman & Barry Smit, Vulnerability to Climate Change Hazards and Risks: Crop and Flood Insurance, 50 CAN. GEOGRAPHER 217 passim (2006).
129. See Milton Friedman, Have Monetary Policies Failed?, 62 AM. ECON. REV. 11, 12 (1972) ("There was no need for monetary authorities to permit a decline of one-third in the quantity of money. They could have prevented a decline and produced an increase. If they had, I do not believe the great depression would have occurred. In that sense, monetary policy failed.");
130. see also Francis A. Bottini, Jr., Comment, An Examination of the Current Status of Rating Agencies and Proposals for Limited Oversight of Such Agencies, 30 SAN DIEGO L. REV. 579, 610 (1993) ("Too much regulation inhibits economic growth by increasing costs and making capital harder to raise.").
131. See supra notes 62-63 and accompanying text.
132. Whether efficiency should also be judged by whether the financial system being stabilized is itself efficient is beyond the scope of this Article, which assumes for analysis purposes that the existing financial system is efficient and thus preserving it is a public good. For a discussion of whether the collapse of a financial system sometimes could, in the long run, be beneficial for society, see supra notes 75-77 and accompanying text.
133. See RICHARD A. POSNER, ECONOMIC ANALYSIS OF LAW § 1.2, at 13-14 (4th ed. 1992) (discussing this "Kaldor-Hicks" standard as the operating standard of efficiency); accord Louis Kaplow & Steven Shavell, Fairness Versus Welfare, 114 HARV. L. REV. 961, 1015 (2001).
134. See infra notes 273-80 and accompanying text (computing the cost-benefit efficiency of regulating systemic risk by separately recognizing R, the cost of regulation).
135. See Yamaguchi, supra note 7, at 2.
136. See Steven A. Ramirez, The Law and Macroeconomics of the New Deal at 70, 62 MD. L. REV. 515, 543-44 (2003). The FDIC scheme insures each depositor's accounts up to $100,000 at each insured institution. Certain accounts may have higher limits, such as Individual Retirement Accounts, which have a limit of $250,000. FED. DEPOSIT INS. CORP., INSURING YOUR DEPOSITS, available at http://www.fdic.gov/deposit/deposits/ insuringdeposits/iyd.pdf.
137. Davis, supra note 18, at 124-26; see Eichberger & Summer, supra note 21, at 1.
138. For an analysis of the international dimensions of regulating systemic risk, see infra Part III.
139. See BASEL COMM. ON BANKING SUPERVISION, INTERNATIONAL CONVERGENCE OF CAPITAL MEASUREMENT AND CAPITAL STANDARDS: A REVISED FRAMEWORK 2-5 (2006), available at http://www.bis.org/publ/bcbsl28.pdf.
140. Id.
141. MARC B. LAMBRECHT, THE BASEL II RATING: ENSURING ACCESS TO FINANCE YOUR BUSINESS 9 (2005);
142. see also Jaime Caruana, A Review of the New Basel Capital Accord, in MARKET DISCIPLINE ACROSS COUNTRIES AND INDUSTRIES 25 (Claudio Bono et al. eds., 2004).
143. See Kaufman, supra note 9, at 23; cf. POSNER, supra note 34, at 461 (arguing that the widespread bank failures during the 1930s were "thought, perhaps erroneously, to have been an important cause of the severity of the business contraction," resulting in excessive banking regulation).
144. Kaufman, supra note 9, at 24.
145. Id.
146. Id.
147. See Jane D'Arista, Financial Regulation in a Liberalized Global Environment, in INTERNATIONAL CAPITAL MARKETS: SYSTEMS IN TRANSITION 75, 76 (John Eatwell & Lance Taylor eds., 2002) (discussing reciprocal flight of American and British banking activity to avoid domestic regulation).
148. Eichberger & Summer, supra note 21, at 22 ("Banks which face a binding capital adequacy constraint and whose firms are successful will end up with positive, but lower equity value than in a situation without regulation. Thus, in the following period, they are likely to be constrained again. Hence, capital adequacy constraints affect[] also the capacity of banks to build up equity value.").
149. See Frank Partnpy, Why Markets Crash and What Law Can Do About It, 61 U. PITT L. REV. 741, 781-82 (2000) (arguing that bank capital adequacy requirements are "seriously flawed" because their heavy reliance on credit ratings leads to inaccuracies, banks are able to use derivatives to add risk in ways that these requirements do not take into account, and such requirements also "rely on short-term measures of [earnings] volatility that do not capture the risks of bank failure").
150. These agencies include the Department of the Treasury, the SEC, and the Commodity Futures Trading Commission. PRESIDENT'S WORKING GROUP, supra note 6, at cover page.
151. Id. at 29-43.
152. Bemanke has observed that "provisionalfly]" the recommendations of the President's Working Group "apparendy have been effective" in that hedge-fund failures have not, "for the most part," resulted in losses to creditors and counterparties, and there is a "general perception among market participants . . . that hedge funds are less highly leveraged" (though he notes the possibility of non-transparent leverage). Bemanke, supra note 6, at 2. However, "some concerns about counterparty risk management remain and may have become even more pronounced given the increasing complexity of financial products" and the fact that "hedge funds have greatly expanded their activities and strategies." Id. Subsequent to Bemanke's report, a consensus has arisen-contrary to the "general perception" Bemanke refers to above-that hedge funds are now much more highly leveraged than ever.
153. See, e.g., Randall Smith & Susan Pulliam, Outer Limits: As Funds Leverage Up, Fears of Reckoning Rise, WALL ST. J., Apr. 30, 2007, at Al.
154. U.S. GEN. ACCOUNTING OFFICE, supra note 6, at 24; see Investor Protection and the Regulation of Hedge Funds Advisers: Hearing Before the S. Comm. on Banking, Housing, and Urban Affairs, 108th Cong. (2004) (testimony of William H. Donaldson, Chairman, SEC), available at http://www.sec.gov/news/testimony/ts071504whd.htm.
155. See Mara der Hovanesian,The SEC Isn't Finished with Hedge Funds, BUS. WK., July 17, 2006, at 34.
156. For additional non-systemic problems that might be within the province of SEC regulation, see Paredes, supra note 4, at 990-1004.
157. See, e.g., PRESIDENT'S WORKING GROUP, supra note 6; Chan et al., supra note 13; Timothy F. Geithner, President and CEO, Fed. Reserve Bank of N.Y., Hedge Funds and Their Implications for the Financial System, Keynote Address Before the Federal Reserve Bank of New York 3 (Nov. 17, 2004), available at www.newyorkfed.org/newevents/ speeches/2004/gei041117.html;
158. see also COUNTERPARTY RISK MGMT. POLICY GROUP II, TOWARD GREATER FINANCIAL STABILITY: A PRIVATE SECTOR PERSPECTIVE (2005), available at http://www.crmpolicygroup.org/ docs/CRMPG-II.pdf (recognizing systemic risk as the central issue of hedge-fund failure).
159. Paredes, supra note 4, at 999 (citations omitted); accord Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).
160. See Greg Ip et al., Stronger Steps: Fed Offers Banks Loans To Ease Credit Crisis, WALL ST. J., Aug. 18, 2007, at Al; Finance Glossary, supra note 53, at http://www.duke.edu/%7Echarvey/ Classes/wpg/bfglosd.htm (last visited May 14, 2008).
161. Smith etal., supra note 2, at Al.
162. See Ip et al., supra note 111, at Al ("[T]he [Fed's] discount window's reach in the current crisis is limited by the fact that only banks can use it, and they aren't the ones facing the greatest strains.").
163. Cf. Seth Carpenter & Selva Demiralp, The Liquidity Effect in the Federal Funds Market: Evidence from Daily Open Market Operations, 38 J. MONEY, CREDIT & BANKING 901, 918-19 (2006) (concluding that although a change in monetary policy can begin to affect the cost of capital within a day, its full effects can take much longer); Serena Ng, Fed Fails So Far in Bid To Reassure Anxious Investors, WALL ST. J., Aug. 21, 2007, at Al. Because financial markets are tightly coupled, spiraling events may well occur rapidly, within days. See infra note 120.
164. For an in-depth analysis of the subprime mortgage crisis, its impact on financial markets, and its application to the principles discussed in this Article, see Schwarcz, supra note 1.
165. See supra notes 46-55 and accompanying text.
166. See supra note 41 and references therein.
167. See supra notes 36-37 and accompanying text.
168. See, e.g., DAVIS, supra note 18, at 127-28 (describing how markets are depressed when failing institutions are forced by creditors to liquidate their assets in distress sales);
169. see also Cifuentes et al., supra note 64, at 11 ("[RJecent theoretical literature on banking and financial crises . . . has emphasizes [sic] the limited capacity of the financial markets to absorb sales of assets."); infra note 125 and accompanying text.
170. These spiraling events may well occur rapidly, within days. See, e.g., Systemic Risk: Examining Regulators' Ability To Respond to Threats to the Financial System: Hearing Before the H. Comm. on Financial Services, 110th Cong. 1 (2007) (testimony of Richard Bookstaber), available at http://www.house.gov/apps/list/hearing/financialsvcs-dem/htl002072.shtml (observing the "tendency for the markets to move rapidly into a crisis mode," and referring to this tendency, by analogy to engineering, as "tight coupling");
171. see also Michael Mandel, The Economy's Safety Valve, BUS. WK., Oct. 22,2007, at 34, 37 (quoting Professor Barry Eichengreen that "[t]he different components of the financial system are tightly linked to each other").
172. MILTON FRIEDMAN & ANNA JACOBSON SCHWARTZ, A MONETARY HISTORY OF THE UNITED STATES 1867-1960, at 311 (1963). Such a panic can occur, for example, when depositors and investors "fear that means of payment will be unobtainable at any price." Bordo et al., supra note 23, at 7.
173. Deposit Insurance: Hearing Before the S. Comm. on Banking, Housing, and Urban Affairs, 108th Cong. (2003) (statement of Alan Greenspan, Chairman, U.S. Fed. Reserve Sys.), available at http://www. federalreserve.gov/boarddocs/testimony/2003/20030226/default.htm.
174. See DAVIS, supra note 18, at 121.
175. See supra notes 116-20 and accompanying text.
176. To some extent this vicious cycle is exacerbated by the common requirement that a securities account be adjusted in response to a change in the market value of the securities. An investor, for example, may buy securities on credit from a securities broker-dealer, securing the purchase price by pledging the securities as collateral. To guard against the price of the securities falling to the point where their value as collateral is insufficient to repay the purchase price, the broker-dealer requires the investor to maintain a minimum collateral value. If the market value of the securities falls below this rninimum, the broker-dealer will issue a "margin call" requiring the investor to deposit additional collateral, usually in the form of money or additional securities, to satisfy this minimum. Failure to do so triggers a default, enabling the broker-dealer to foreclose on the collateral. ZVI BODIE, ALEX KANE & ALAN J. MARCUS, INVESTMENTS 78-79 (7th ed. 2008). Requiring investors to "mark-to-market" in this fashion is generally believed to reduce systemic risk.
177. See, e.g., Gikas A. Hardouvelis & Panayiotis Theodossiou, The Asymmetric Relationship Between Initial Margin Requirements and Stock Market Volatility Across Bull and Bear Markets, 15 REV. FIN. STUD. 1525,1554-55 (2002) (finding a correlation between higher margin calls and decreased systemic risk, and speculating that higher margin calls may bleed the irrationality out of the market until only sound bets are left). Nonetheless, it can cause "perverse effects on the stability of a financial system" during times of market turbulence, when forcing sales of assets to meet margin calls can depress asset prices, requiring more forced sales (which, in turn, will depress asset prices even more), causing the downward spiral. Cifuentes et al., supra note 64, at 32;
178. see also Clifford De Souza & Mikhail Smirnov, Dynamic Leverage: A Contingent Claims Approach to Leverage for Capital Conservation, J. PORTFOLIO MGMT., Fall 2004, at 25, 28 (arguing that in a bad market, short-term pressure to sell assets to raise cash for margin calls can lead to further mark-to-market losses for remaining assets, which triggers a whole new wave of selling, with the process repeating itself until markets improve or the firm is wiped out, and referring to this process as a Critical Liquidation Cycle). The existence of leverage makes this cycle more likely and amplifies it if it occurs. Id. at 26-27, 37 (explaining that leverage decreases the amount of capital relative to potential cash obligations, and that the Critical Liquidation Cycle begins whenever this equity falls below the level necessary to meet the firm's obligations and equity cannot be raised by selling assets without incurring losses).
179. Cf. Andrew Elek & Dominic Wilson, The East Asian Crisis and International Capital Markets, ASIAN-PAC. ECON. LITERATURE, May 1999, at 1, 7 (describing investor withdrawal of capital and resulting large-scale insolvency due to market illiquidity).
180. See, e.g., Partnoy, supra note 102, at 782-83 (characterizing this approach as a "circuit breaker"). Capital markets in the United States, for example, were closed for this purpose following the 9/11 attacks. Margo McCall, Uncertainty Follows Tragedy, WIRELESS WK., Sept. 17, 2001, at 1.
181. Partnoy, supra note 102, at 783 (arguing that closing down markets "may actually fuel panic," and explaining that "[t]here is no empirical evidence supporting this point, but it seems equally plausible that investor cognitive error would increase more during the period in which the circuit breaker [closing down the market] is in effect than it would have increased during a period of panic selling").
182. Eduardo Porter, Shanghai What-If: How a Shock Can Become a Shock Wave, N.Y. TIMES, Mar. 4, 2007, at WK3 (quoting observation by Alan Blinder, Princeton University economist and former Vice Chairman, Board of Governors, U.S. Fed. Reserve Sys.).
183. Cf. DAVIS, supra note 18, at 12 (observing that mispricing can lead to increased market vulnerability); Bordo et al., supra note 23, at 10 (discussing how "speculative mama" can turn into market crisis).
184. Cf. POSNER, supra note 34, at 446 (observing that investors, who are risk-averse, will want to be compensated for risk that cannot be eliminated).
185. Paul Krugman, Editorial, The Big Meltdown, N.Y. TIMES, Mar. 2, 2007, at A17.
186. Id. Internationally, the decline in the risk premium has been even more pronounced, with high-yield European bonds commanding nearly sixteen percent interest in 2002 but recently less than three percent. Ravi Balakrishnan et al., Globalization, Gluts, Innovation or Irrationality: What Explains the Easy Financing of the U.S. Current Account Deficit? 12 (Int'l Monetary Fund, Working Paper No. 07/160,2007).
187. Balakrishnan argues that the decline in the risk premium is due to a liquidity glut. See Balakrishnan, supra note 133, at 11. A participant in a faculty workshop suggested, anecdotally, that the decline might result from hedging, whereby risk gets spread out.
188. Cf. infra notes 159-72 and accompanying text. Risk-spreading, however, would not appear to have more than a marginal effect on risk premiums. In the face of actual risk, well-informed hedging parties would themselves price-in the risk and thereby require that amount to be paid as consideration by the hedged parties. The hedged parties, in turn, would have to pay that price out of the risk premium. This appears no different than banks diversifying risk through the sale of loan participations, which does not significantly reduce the risk premium for borrowers since buyers of loan participations demand compensation for the portion of the risk they are assuming.
189. See Steven L. Schwarcz, Intermediary Risk in a Global Economy, 50 DUKE L.J. 1541, 1557-61 (2001) (discussing loan participations). This Article later argues that spreading risk may well reduce systemic risk by reducing the chance that any given default will cause a chain of institutions to fail, see infra note 172 and accompanying text, but it should not reduce risk within the financial system.
190. Under the availability heuristic, people overestimate the frequency or likelihood of an event when examples of, or associations with, similar events are easily brought to mind. For example, people typically overestimate the divorce rate if they can quickly find examples of divorced friends. Paul Slovic, Baruch Fischhoff & Sarah Lichtenstein, Facts Versus Fears: Understanding Perceived Risk, in JUDGMENT UNDER UNCERTAINTY: HEURISTICS AND BIASES 463, 465 (Daniel Kahneman et al. eds., 1982).
191. Krugman, supra note 132.
192. See, e.g., THOMAS CARGHX ET AL., THE POLITICAL ECONOMY OF JAPANESE MONETARY POLICY 108 (1997) (discussing "bandwagon behavior" and explaining that even when investors believe prices are abnormally high, they may invest further under the assumption that prices will rise for some time, and they will be the first to sell before prices fall).
193. Cf. Steven L. Schwarcz, Rethinking the Disclosure Paradigm in a World of Complexity, 2004 U. ILL. L. REV. 1, 14 (discussing this phenomenon).
194. A famous example of irrational investment arose out of the tulip trade in seventeenth-century Holland. Certain tulips were highly prized and sold for thousands of guilder. Almost everyone got caught up in the excitement of buying and selling tulip bulbs, usually on credit and with the intention of making a quick profit. When the market finally crashed, many who speculated on credit were left with crushing debts. Sam Segal, Tulips Portrayed: The Tulip Trade in Holland in the 17th Century, in THE TULIP: A SYMBOL OF TWO NATIONS 17-20 (Michiel Roding & Hans Theunissen eds., 1993). Irrational investment trends can start quite easily. If, for example, a particular stock unexpectedly gains in value, the losers (for example, those shorting the stock) will tend to withdraw from that market, and the winners will tend to increase their investment, driving up the price even further. Soon, other winners are attracted to the stock, and other losers cut their losses and stop shorting the stock. This process is aided by almost inevitable explanations of why it is "rational" for the price to keep going up and why the traditional relationship of price to earnings does not apply. Even investors who recognize the bubble as irrational may buy in, hoping to sell at the height of the bubble before it bursts.
195. RICHARD BOOKSTABER, A DEMON OF OUR OWN DESIGN: MARKETS, HEDGE FUNDS, AND THE PERILS OF FINANCIAL INNOVATION 169-70 (2007). In these ways, price movements can become somewhat self-sustaining. Id.
196. In the banking context, some scholars argue that the degree of information asymmetry within a given banking system is the main determinant of whether a similar trigger event will lead to a small panic or a large one, and that systems with large or heavily interconnected banks are less likely- because of institutional system-wide self-monitoring (and correspondingly less information asymmetry among system participants)-to experience large panics, whereas systems characterized by small and highly independent banks lack the means for effective self-monitoring. Gary Gorton & Lixin Huang, Bank Panics and the Endogeneity of Central Banking, 53 J. MONETARY ECON. 1613, 1627-28 (2006). Outside of banking, however, there is uncertainty. If a particular financial system is linear, like a tree of dominoes, it should be possible to calculate possible consequences.
197. See BOOKSTABER, supra note 139, at 155-56. But if the system is non-linear, like the weather, even minute changes in the triggering event could lead to large macro differences in the outcome, making it difficult to calculate long-term consequences. Id. at 228-30.
198. This collateral-value restriction on margin loans is imposed under Regulations G, T, U, and X, which require a two-to-one collateral-value-to-loan ratio on loans to purchase margin (that is, publicly-traded) stock, secured by such stock. 12 C.F.R. §§ 207, 220, 221, 224 (2008).
199. Greg Lumelsky, Does Russia Need a Securities Law?, 18 NW. J. INT'L L. & BUS. Ill, 122-23 (1997) ("Since before the New Deal, the U.S. philosophy of securities regulation has been based on the provision of continuous, accurate, public disclosure as a remedy against fraud and as a way to reduce risk associated with the purchase and sale of securities.").
200. Id.
201. Cf. POSNER, supra note 34, at 146 (indicating that investors will want to be compensated for risk that cannot be eliminated).
202. See supra note 104 and accompanying text.
203. Systemic risk can be likened to a tragedy of the commons. See supra notes 63-67 and accompanying text.
204. Cf. Roberta Romano, A Thumbnail Sketch of Derivative Securities and Their Regulation, 55 MD. L. REV. 1, 79-80 (1998) (arguing that improved disclosure would not have prevented hedge-fund problems).
205. See STUART A. McCRARV, HEDGE FUND COURSE 255 (2005) ("Investors may demand more disclosures [from hedge funds] than the minimum required . . . [and] receive as much information as would be disclosed if the investment was registered."); 2 HOUSE OF COMMONS TREASURY COMMITTEE, PRIVATE EQUITY: TENTH REPORT OF SESSION 2006-07, 2007, H.C. 567-II at 93 (Eng.) ("[Private equity] investors frequently demand, and receive, far more comprehensive and detailed disclosures than investors in public companies, both on the fund in which they have invested and on the companies represented in the fund's portfolio.").
206. BOOKSTABER, supra note 139, at 221; cf. Romano, supra note 147, at 81 (arguing that if government imposes too much regulation, less experienced investors might be lulled into engaging in derivatives trading).
207. See Schwarcz, supra note 138, at 4 (arguing that the increasing complexity of transactions and markets is making disclosure less able to reduce information asymmetry and that supplementary approaches should be sought to reduce such asymmetry).
208. Aaron Lucchetti & Serena Ng, Credit and Blame: How Rating Firms' Calls Fueled Subprime Mess, WALL ST. J., Aug. 15, 2007, at Al (quoting a market observer);
209. see also Daniel Andrews, The Clean Up: Investors Need Better Advice on Structured Finance Products, 26 INT'L FIN. L. REV. 14, 14 (Sept. 2007) ("Investors have the prospectuses to rely on, but the reality is that they have not taken any responsibility for reading the detail of the documentation or digesting the risks involved."); Steven L. Schwarcz, Disclosure's Failure in the Subprime Mortgage Crisis, 2008 UTAH L. REV. (forthcoming) (explaining why complexity caused disclosure to fail in the subprime mortgage crisis).
210. See, e.g., LOWENSTEIN, supra note 36, at 231 (arguing that derivatives are too complex for regulators to understand the extent of the risks they create, and that disclosure alone will not enable investors to understand the risks).
211. See Adam R. Waldman, Comment, OTC Derivatives & Systemic Risk: Innovative Finance or the Dance into the Abyss?, 43 AM. U. L. REV. 1023, 1055-56 (1994).
212. For an analysis of that larger debate, see Romano, supra note 147.
213. See, e.g., Ludger Hentschel & Clifford W. Smith, Jr., Risks in Derivatives Markets: Implications for the Insurance Industry, 64 J. RISK & INS. 323, 342 (1997) (arguing that derivatives can increase risk if they are used for speculation rather than hedging); Frank Partnoy &
214. David A. Skeel, Jr., The Promise and Perils of Credit Derivatives, 75 U. CIN. L. REV. 1019, 1040 (2007) (same); Michel Aglietta, Financial Market Failures and Systemic Risk 7-12, 15-26 (Centre d'Études Prospectives et d'Informations Internationales, Working Paper No. 1996-01, 1996) (same); Michael R. Darby, Over-the-Counter Derivatives and Systemic Risk to the Global Financial System 6-18 (Nat'l Bureau of Econ. Research, Working Paper No. 4801, 1994) (same).
215. But cf. Ludger Hentschel & Clifford W. Smith, Jr., Derivatives Regulation: Implications for Central Banks, 40 J. MONETARY ECON. 305, 320-23 (1997) (arguing that derivatives reduce systemic risk);
216. Myron S. Scholes, Global Financial Markets, Derivatives Securities, and Systemic Risk, 12 J. RISKS & UNCERTAINTY 271, 277-85 (1996) (same).
217. See, e.g., 11 U.S.C. § 546 (2000 & Supp. 2006). These derivatives-netting provisions apply to all derivatives, whether used for speculation or for hedging. See id.
218. See, e.g., Enron Corp. v. J.P. Morgan Sec., 325 B.R. 671, 684 (Bankr. S.D.N.Y. 2005); Rhett G. Campbell, Financial Markets Contracts and BAPCPA, 79 AM. BANKR. L J. 697 passim (2005);
219. Ellen H. Clark, Developments in Derivatives and Synthetic Securitization Following the US Bankruptcy Reforms of 2005, in INNOVATIONS IN SECURITISATION YEARBOOK 96 (Jan Job de Vries Robbé & Paul U. Ali eds., 2006) ("By permitting solvent counterparties to terminate their contracts without incurring additional risk, close-out netting enhances liquidity, and the certainty provided by allowing a solvent counterparty to close-out its hedges will prevent market disruption.");
220. Edward R. Morrison & Joerg Riegel, Financial Contracts and the New Bankruptcy Code: Insulating Markets from Bankrupt Debtors and Bankruptcy Judges, 13 AM. BANKR. INST. L. REV. 641, 642, 647, 660, 663 (2005); Christopher J. Redd, Treatment of Securities and Derivatives Transactions in Bankruptcy: Part I, AM. BANKR. INST. J., July-Aug. 2005, at 36, 37.
221. It should be noted in this context that the potential for systemic risk from derivatives, absent these bankruptcy-netting provisions, primarily results from other U.S. bankruptcy law provisions that generally impose an automatic stay-the Bankruptcy Code's prohibition on creditors seizing the assets of firms in bankruptcy-and invalidate ipso facto clauses. Franklin R. Edwards &
222. Edward R. Morrison, Derivatives and Systemic Risk: What Role Can the Bankruptcy Code Play?, in SYSTEMIC FINANCIAL CRISES: RESOLVING LARGE BANK INSOLVENCIES 347-50 (Douglas D. Evanoff & George G. Kaufman eds., 2005). Although the insolvency laws of few, if any, foreign countries include netting provisions for derivatives, such provisions may be unnecessary to the extent those laws lack terms imposing automatic stays or invalidating ipso facto clauses. Foreign derivatives contracts, on the other hand, may engender other concerns, such as whether such contracts are enforceable or, instead, illegal as gambling contracts. Interview with Michael Crystal, Queen's Counsel, at the International Insolvency Institute's Seventh Annual Conference, "Understanding Derivatives: Dissecting Complex Financial Instruments" (June 12, 2007) (observing that, outside the United States, there are "huge re-characterization and fraud risks in credit derivatives").
223. See, e.g., Cifuentes et al., supra note 64, at 24-28 (finding a non-linear response to a shock with respect to a number of bank interlinkages in that a credit structure diversified among two or three banks can trigger, in the case of a bank's default, significant systemic contagion to other banks, whereas that "contagion disappears when the number of linkages is high enough to allow banks to stand the losses without selling illiquid assets");
224. see also Gretchen Morgenson, Arcane Market Is Next To Face Big Credit Test, N.Y. TIMES, Feb. 17, 2008, at Al (questioning how the credit-default-swap market, which is untested and unregulated, will react to increases in corporate defaults); Gretchen Morgenson, In the Fed's Cross Hairs: Exotic Game, N.Y. TIMES, Mar. 23, 2008, at BU1 (speculating that Bank of America's takeover of Countrywide and J.P. Morgan's takeover of Bear Steams might have been arranged by regulators in part to eliminate credit-default swaps on Bear Stearns and Countrywide bonds).
225. See Partnoy & Skeel, supra note 155, at 1023.
226. STEVEN L. SCHWARCZ, STRUCTURED FINANCE: A GUIDE TO THE PRINCIPLES OF ASSET SECURITIZATION 12-14 n.37 (3d ed. supplemented through Mar. 2007).
227. Id. at 12-2.
228. Id. at 12-5.
229. Id. at 12-7.
230. Id.
231. Id. at 12-8.
232. See Moisés Naín, Mexico's Larger Story, 99 FOREIGN POL'Y 112, 121-22 (1995).
233. See infra notes 173-77 and accompanying text.
234. Cf. supra note 159.
235. For example, convergent hedging strategies could concentrate rather than diversify risk. Cf. supra note 47. Hedging strategies are sometimes also unrealistic and, as illustrated by LTCM, can fail spectacularly when market liquidity dries up. See Waldman, supra note 153, at 1056.
236. Cf. supra note 159.
237. DAVIS, supra note 18, at 272 (arguing that although "derivatives have increased linkages between market segments, [causing] disruption in one [market] to more readily feed into others," spreading the risk "more widely across the financial system . . . may help to diffuse financial instability and prevent systemic risk");
238. Alan Greenspan, Chairman, Bd. of Governors, U.S. Fed. Reserve Sys., Risk Transfer and Financial Stability: Remarks at the Federal Reserve Bank of Chicago's Forty-First Annual Conference on Bank Structure (May 5, 2005), available at http://www.federalreserve.gov/Boarddocs/Speeches/2005/
239. See supra note 46 and accompanying text.
240. For an illustration of this potential occurrence, see the example discussed supra notes 116-20 and accompanying text.
241. The government report issued after LTCM's near-failure recommended a weak variant on this approach: increased disclosure by public companies of exposures to highly leveraged hedge funds. See supra note 104 and accompanying text.
242. Compare supra notes 118-20 and accompanying text, discussing in the context of a generic example how contractual counterparties rush to try to close out or otherwise protect their positions after a large hedge fund or private-equity company defaults.
243. Henry Qrdower, Demystifying Hedge Funds: A Design Primer, 7 U.C. DAVIS BUS. L.J. 323, 370 (2007). Lending limits apply to both individual bank customers and lending between banks. See Federal Deposit Insurance Corporation Improvement Act of 1991, Pub. L. No. 102-242, § 308 (codified at 12 U.S.C. § 371B-2).
244. JOE REIF, SERVICES: THE EXPORT OF THE 21ST CENTURY 58 (1997); see also Stijn Claessens, Benefits and Costs of Integrated Financial Services Provision in Developing Countries, in BROOKINGS-WHARTON PAPERS ON FINANCIAL SERVICES 85, 106 n.50 (Richard Herring & Robert E. Litan eds., 2003) ("Non-bank financial institutions, not just banks, have the potential to be sources of systemic risk . . . [because] [i]n many countries, information service providers, such as credit-card companies, provide near-banking services . . . [and] non-banks are offering forms of payment services [that resemble services provided by banks].");
245. Timothy F. Geithner, Speech Before the Conference on Systemic Financial Crises at the Federal Reserve Bank of Chicago (Oct. 1, 2004), available at http://www.ny.frb.org/newsevents/speeches /2004/gei041001.html ("There has also been a substantial convergence in the types of financial transactions bank-centered and non-bank affiliated financial intermediaries perform.").
246. U.S. non-bank financial intermediaries, which are not regulated under the same constraints applied to banks, account for most of the assets of financial institutions. Geithner, supra note 178.
247. See John Lipsky, First Deputy Managing Dir., Int'l Monetary Fund, Through the Looking Glass: The Links Between Financial Globalization and Systemic Risk, Speech at the Joint IMF Federal Reserve Conference (Sept. 27, 2007), available at http://www.imf.org/external/np/speeches/2007/092707. htm.
248. See Ben S. Bernanke, Chairman, Bd. of Governors, U.S. Fed. Reserve Sys., Remarks at the New York University Law School (Apr. 11,2007), available at http://www.federalreserve.gov/boardDocs/speeches/2007/ 20070411/default.htm (observing that while "targeted government regulation and intervention can sometimes benefit the economy . . . the market itself can often be used to achieve regulatory objectives").
249. Id. (noting that hedge-fund counterparties-most notably large commercial arid investment banks-are creditors with "a clear economic incentive to monitor and perhaps impose limits on hedge funds' risk-taking, as well as an incentive to protect themselves from large losses should one or more of their hedge-fund customers fail").
250. Id.
251. Id.
252. See Counterparty Credit Risk Management Is Best Defense Against Systemic Risk Linked to Hedge Funds, RES. UPDATE (Fed. Reserve Bank of N.Y., New York, N.Y.), Oct. 2007, at 1, available at http://www.ny.frb.org/research/research-update /10-07up.pdf (citing research indicating that "despite the unique risk challenges posed by hedge funds, the practices used by financial institutions to manage counterparty credit risk are still the best starting point for limiting the funds' potential for generating systemic disruptions").
253. Cover letter included at beginning of PRESIDENT'S WORKING GROUP, supra note 6 (observing that "excessive leverage can increase the likelihood of a general breakdown in the functioning of financial markets" by increasing the likelihood of transmitting problems).
254. DAVIS, supra note 18, at 40 ("[I]ncreased corporate debt in relation to equity, assets or cash flow is likely to lead to a greater probability of bankruptcy.").
255. Cf. 11 U.S.C. § 303 (discussing failure to pay debts as the basis for involuntary bankruptcy).
256. Reducing leverage also occurs reactively insofar as investors experiencing a financial collapse will be more cautious and thus incur less leverage in the future. This, however, is a reaction to-not a means to mitigate-the collapse, and it does not reduce the harm that has been caused. Moreover, those investors may well, over time, fall into the pattern of alternating skittishness and optimism, discussed infra notes 255-59 and accompanying text, so that lessons about leverage learned from a collapse are eventually disregarded.
257. For example, at least in the United States, interest paid on debt is tax deductible whereas a dividend paid on equity is not. Also, the cost of debt is usually lower than the cost of equity because debt is a less risky investment than equity. See DAVIS, supra note 18, at 40.
258. According to financing "trade-off" theory, the optimal amount of leverage is determined by the amount of tax-breaks and other benefits received for debt assumed relative to the costs of that debt. James L. Berens & Charles J. Cuny, The Capital Structure Puzzle Revisited, 8 REV. FIN. STUD. 1185, 1185 (1995). Moderate leverage may prove beneficial, but too much leverage will hurt a company and its valuation. See Murillo Campello, Debt Financing: Does It Boost or Hurt Firm Performance in Product Markets?, 82 J. FIN. ECON. 135, 168 (2006).
259. See supra notes 91-93,100-02 and accompanying text.
260. Susan Schmidt Bies, Governor, Bd. of Governors, U.S. Fed. Reserve Sys., Basel II Developments in the United States, Remarks Before the Institute of International Bankers (Sept. 26, 2005), available at http://www. federaheserve.gov/boarddccs/speeches/2005/20050926/default.htm.
261. Cf. supra note 191.
262. Cf. Schwarcz, supra note 78, at 444-45 (discussing lack of liquidity as the primary cause of bankruptcy).
263. See infra notes 222-35 and accompanying text. This also responds directly to the crux of a systemic collapse because systemic risk is (largely) a liquidity phenomenon: market systemic risk is systemic risk that impairs market liquidity, and institutional systemic risk is, at least to the extent it involves banks, systemic risk that impairs money liquidity.
264. Cf. supra notes 116-20 and accompanying text.
265. The "liquidity injection" by the U.S. Federal Reserve, in response to the recent subprime mortgage crisis, did not actually ensure liquidity but merely provided a more attractive borrowing environment for banks.
266. See, e.g., Jeremy W. Peters, The Banks Roll Up Their Sleeves, N.Y. TIMES, Aug. 19, 2007, at WK2 (observing that when the Federal Reserve makes "liquidity injections" into the banking system, "the Fed doesn't even use real money," and explaining that liquidity results from offering Fed loans to banks at the discount rate, a lower interest rate than the "fed funds rate" that banks would charge other banks on interbank loans). Moreover, that "liquidity injection" affected only banks, not financial markets, directly. See supra note 113 and accompanying text.
267. Bordo et al., supra note 23, at 19.
268. Id.
269. Cf. id. at 21 ("The Federal Reserve Bank of New York acted as an effective lender of last resort, providing needed liquidity to the money market and preventing panic").
270. Cf. Jonathan R. Macey & Maureen O'Hara, Solving the Corporate Governance Problems of Banks: A Proposal, 120 BANKING L.J. 326, 328-29 (2003) (discussing banks "foist[ing] some of their losses onto . . . the federal taxpayers whose funds replenish the federal insurance fund when it is depleted");
271. Partnoy, supra note 102, at 757-84 (discussing moral hazard in the context of market crashes and lenders of last resort); Steven L. Schwarcz, Sovereign Debt Restructuring: A Bankruptcy Reorganization Approach, 85 CORNELL L. REV. 956, 961-66 (2000) (discussing the moral hazard and other costs created when the IMF acts as a lender of last resort to financially troubled nations).
272. See DAVIS, supra note 18, at 123 ("An essential feature [of a liquidity-provider of last resort] is that its operation should be uncertain for any particular institution in difficulties . . . . "); Partnoy, supra note 102, at 784 (suggesting this approach). A policy of constructive ambiguity nonetheless is imperfect, requiring difficult political choices of whom to exclude. See Systemic Risk Hearing, supra note 1, at 11, 38.
273. Tobias Knedlik, Implementing an International Lender of Last Resort 9-10 (Halle Inst, for Econ. Research, IWH-Discussion Paper No. 20, 2006). Qualification criteria could include predictors related to the chance of default, such as bank independence and the presence of corruption. Repayment incentives may include disqualification for future help or "interest rate discounts for fast repayments." Id. at 10.
274. Gregory Moore, Solutions to the Moral Hazard Problem Arising from the Lender-of-Last-Resort Facility, 13 J. ECON. SURV. 443, 470 (1999). Another approach to controlling moral hazard- shaming those who need to borrow from a liquidity-provider of last resort,
275. see id.-is likely to backfire, because society wants the borrowing to occur to avoid systemic risk.
276. Kenneth B. Noble, New Deal Bank Acts Turn 50, N.Y. TIMES, June 17, 1983, at Dl ("The E.D.I.C. is financed by premiums paid by insured banks. Each bank is assessed one-twelfth of 1 percent of its insured deposits. Accounts are insured for up to $100,000 each, although the agency commonly will reimburse depositors for more.").
277. See, e.g., Adam Lerrick, Funding the IMF: How Much Does It Really Cost?, Q. INT'L ECON. REP., Nov. 2003, at 1, available at http://www.house.gov/jec/imf/l-18-03.pdf (observing that IMF participation is estimated to cost U.S. taxpayers $1.9 billion annually because IMF loans have artificially low interest rates); Schwarcz, supra note 202, at 963-64 (discussing how the IMF raises money from taxpayers of member-nations); id. at 965-66 (observing that the return to IMF member-nations is not only "less than a market rate of interest" but, "[i]n some cases, . . . even below the member-State's own cost of funds").
278. Cf. Schwarcz, supra note 202, at 965 n.45 ("Only a foolish investor would seek a rate of return that is equal to or less than its cost of funds.").
279. Privatization might even occur indirectly. Cf. Smith et al., supra note 2, at A8 (observing that, in response to the subprime mortgage crisis, several large banks in the United States "discussed with the Fed the possibility of borrowing a total of $75 billion to be used to buy" mortgage-backed securities, to support their value).
280. The global capital markets had approximately $65 trillion debt securities outstanding as of September 30, 2006. Bank for Int'l Settlements, BIS Q. REV., Dec. 2006, at Statistical Annex, A85-A100; see also Naím, supra note 167, at 122-23 ("Today, the magnitude of the funds controlled by private investment managers makes the volumes typically supplied by the IMF and the World Bank almost irrelevant.").
281. Schwarcz, supra note 202, at 987, 993.
282. See infra note 222 and accompanying text.
283. Cf. Schwarcz, supra note 202, at 986 (discussing similar reasons why a priority would be needed in a sovereign-debt restructuring context to attract financing).
284. See 11 U.S.C. § 364 (2000) (authorizing priorities for so-called "DIP," or debtor-in-possession, loans).
285. Even the IMF, when acting as a lender of last resort to sovereign nations, has priority over the nation's existing creditors. Schwarcz, supra note 202, at 988.
286. Steven L. Schwarcz, The Easy Case for the Priority of Secured Claims in Bankruptcy, 47 DUKE L.J. 425, 425 (1997). Although that article deals with secured lending priorities, its argument applies equally to any set of lending priorities that arise merely by operation of law.
287. See id. at 430.
288. In this context, overinvestment means that a borrower invests proceeds of the new-money credit in a project that is less valuable than the proceeds. If the borrower fails, the prior creditors will suffer losses.
289. Schwarcz, supra note 202, at 989-90.
290. Id.
291. See infra note 232 and accompanying text.
292. Cf. Schwarcz, supra note 202, at 990 (suggesting a similar approach for the IMF to disburse capital-market funds, as a lender of last resort, to troubled nations). As a credit matter, the lenders would be in the same position as if they had made the loan directly to the institution. Id.at 990 & n.199.
293. Cf. DAVIS, supra note 18, at 268 (suggesting there may be a need for a "market maker of last resort" to protect financial markets).
294. Cf. Allaudeen Hameed et al., Stock Market Declines and Liquidity 34 (Mar. 28, 2007) (unpublished manuscript, on file with author) (finding that market shocks affect all prices, with "many asset holders [being forced] to liquidate, making it difficult to provide liquidity precisely when the market demands it").
295. Even in the subprime mortgage crisis, with its plummeting prices on mortgage-backed securities, some discount should be sufficient because those prices appear to be well below the real value of the securities.
296. See, e.g., Chris Giles & Krishna Guha, Mortgage Crisis Talks Under Way, FIN. TIMES (London), Mar. 22, 2008, at 1 (reporting that at least one European central bank "strongly" believes "that prices of [mortgage-backed securities] have fallen to levels that imply unrealistically high rates of default").
297. Chris Giles, Mortgage Assets "Are Likely Target," FIN. TIMES (London), Mar. 24, 2008, at 3 (reporting that, in the subprime mortgage crisis, there appears to be imperfect information on the value of outstanding mortgage-backed securities);
298. cf. Gillian Tett, Securities Estimates Revealed in Court, FIN. TIMES (London), Mar. 24, 2008, at 15 ("[T]rading [of mortgage-backed securities] has virtually dried up in many corners of the credit markets, and it is hard to compare prices for these instruments.").
299. Cf. supra note 203 and accompanying text.
300. See, e.g., Tyler Cowen, It's Hard To Thaw a Frozen Market, N.Y. TIMES, Mar. 23, 2008, at BU5 (asking why, in the context of the subprime mortgage crisis, "asset prices don't simply fall enough so that someone buys them and trading picks up again," and answering, "why seek 'fire sale' prices when you might lose your job for doing so?").
301. See Stephen M. Bainbridge, Mandatory Disclosure: A Behavioral Analysis, 68 U. CIN. L. REV. 1023, 1038 (2000) (discussing how herd behavior may have a reputational payoff even if the chosen course of action fails, and arguing that where "the action was consistent with approved conventional wisdom, the hit to the manager's reputation from an adverse outcome is reduced");
302. Paul M. Healy & Krishna G. Palepu, The Fall of Enron, J. ECON. PERSP., Spring 2003, at 3, 18-19 (explaining that a risk-averse fund manager who estimates a stock is overvalued will be apt to "simply follow the crowd" and refrain from acting on his analysis because this course of action will ensure that he will not be blamed for a poor investment decision if the stock ultimately collapses "since other funds made the same mistake").
303. To the extent these moneys are invested in market-rate securities, there should not be losses to taxpayers.
304. Cf. Yamaguchi, supra note 7, at 3 (arguing in favor of augmenting the functions of central banks to act, at least nationally, as lenders of last resort for large non-bank institutions and conglomerates);
305. see also Vikas Bajaj, Central Banks Intervene To Calm Volatile Markets, N.Y. TIMES, Aug. 11, 2007, at Al (reporting on efforts by the European Central Bank, the U.S. Federal Reserve Bank, and other central banks worldwide to coordinate liquidity infusions in their respective nations).
306. To the extent the Federal Reserve Bank has this power, its source would be section 13(3) of the Federal Reserve Act, which, in "unusual and exigent circumstances," enables "the Board of Governors of the Federal Reserve System [to] authorize any Federal reserve bank . . . to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange" if such individual, partnership, or corporation is "unable to secure adequate credit accommodations from other banking institutions." 12 U.S.C. § 343 (2000). Although this may well enable the Federal Reserve to fund failing institutions, it is dubious that it enables the Fed to purchase securities in falling markets.
307. See infra text accompanying notes 338-45.
308. See CHARLES GOODHART ET AL., FINANCIAL REGULATION: WHY, HOW, AND WHERE Now? 192 (1998) (explaining that rigorous liquidity requirements and other banking regulations create "an overly expensive, intrusive and rigid system, with costs that greatly exceed the benefits").
309. See DMITRIS N. CHORAFAS, LIABILITIES, LIQUIDITY, AND CASH MANAGEMENT: BALANCING FINANCIAL RISK 143-44 (2002) (distinguishing market liquidity from institutional liquidity and positing that "it is wise to differentiate between liquidity in a general market sense and an entity's own liquidity, or illiquidity in terms of not meeting liabilities as they fall due, which is default").
310. See supra note 140 and accompanying text.
311. Cf. BOOKSTABER, supra note 139, at 157 (arguing that in non-linear systems, improvised solutions may work better than set rules).
312. See Marcelo Dabós, Too Big To Fail in the Banking Industry: A Survey, in TOO BIG TO FAIL: POLICIES AND PRACTICE IN GOVERNMENT BAILOUTS 141 (Benton E. Gup ed., 2004).
313. Under the "too big to fail" (TBTF) doctrine, governments act to protect large institutions- primarily banks-"to prevent adverse effects on the financial system." Id.
314. See id.
315. Sorkin, supra note 3; see also Paul Krugman, Op-Ed., The B Word, N.Y. TIMES, Mar. 17, 2008, at A19 (describing the purchase of Bear Stearns as a "bailout").
316. See, e.g., Bernanke, supra note 181 (discussing both the mechanisms of market discipline in banking and certain forces, such as market-participant confidence in bailouts, that undermine market discipline).
317. See Albert J. Boro, Jr., Comment, Banking Disclosure Regimes for Regulating Speculative Behavior, 74 CAL. L. REV. 431, 488 (1986) (observing that market discipline can be more efficient than top-down regulation). For a discussion of the direct and indirect costs of regulation, see supra notes 79-84 and accompanying text.
318. See, e.g., Alfred C. Yen, Western Frontier or Feudal Society?: Metaphors and Perceptions of Cyberspace, 17 BERKELEY TECH. L.J. 1207, 1228 n.73 (2002) (characterizing regulation of markets as a necessary response to market imperfections).
319. Cf. Bernanke, supra note 6, at 6 (observing that, to the extent hedge funds are regulated solely through market discipline, government's "primary task is to guard against a return of the weak market discipline that left major market participants overly vulnerable to market shocks"). A market-discipline approach is sometimes used to help solve tragedies of the commons. See supra note 16.
320. Cf. Bernanke, supra note 181 (observing that "[r]eceivership rules that make clear that investors will take losses when a bank becomes insolvent should increase the perceived risk of loss and thus also increase market discipline" and that, in "the United States, the banking authorities have ensured that, in virtually all cases, shareholders bear losses when a bank fails").
321. See Bernanke, supra note 6;
322. Ryan, supra note 6, at 2.
323. See supra note 63 and accompanying text.
324. See, e.g., Boro, supra note 243, at 471;
325. Helen A. Garten; Banking on the Market: Relying on Depositors To Control Bank Risks, 4 YALE J. ON REG. 129, 129-30 & n.l (1986).
326. Bernanke, supra note 6. Professor Romano suggests that the breakdown of market discipline is due simply to human greed.
327. See Romano, supra note 147, at 79 (discussing greed as a central factor that, in the hedge-fund context, "transform[s] a successful hedging or moderately risky investment strategy into one of high-risk speculation"). Bernanke suggests, however, a possible alternative psychological explanation: that "[i]nvestors, perhaps awed by the reputations of LTCM's principals, did not ask sufficiently tough questions about the risks that were being taken to generate the high returns." Bernanke, supra note 6.
328. See Partnoy, supra note 102, at 774.
329. See supra note 42.
330. See supra note 42. Regulators are supposed to ensure that banks follow safe and sound banking practice.
331. See 12 U.S.C. § 93(b)(2)(A)(ii) (2000) (fining banks for recklessly engaging in "unsafe" or "unsound" practices).
332. See supra notes 132-40 and accompanying text. For further examples of regulatory failures of market discipline, see Schwarcz, Protecting Financial Markets, supra note 1.
333. See Claire A. Hill, How Investors React to Political Risk, 8 DUKE J. COMP. & INT'L L. 283, 287-89 (1998) (describing how risk-assessment is especially difficult when it requires extrapolation from dissimilar, heterogeneous events). Scholars sometimes distinguish rare and unpredictable risks from other risks by calling the former "uncertainty." Id. at 287 (citing FRANK H. KNIGHT, RISK, UNCERTAINTY, AND PROFIT (1921)).
334. Id. at 286.
335. Id. at 308; cf. supra note 135.
336. Hill, supra note 255, at 308.
337. Cf. DAVIS, supra note 18, at 277 (arguing that this pattern may reflect "disaster myopia," in which "memories of financial instability can rapidly fade, a process intensified by rapid turnover of staff and/or intense competition").
338. Greenspan, for example, had a serious bias against regulation and assumed market discipline was far better than it actually was. See LOWENSTEIN, supra note 36, at 231.
339. U.S. GOV'T ACCOUNTABILITY OFFICE, PUBL'N No. GAO-02-302, SEC OPERATIONS: INCREASED WORKLOAD CREATES CHALLENGES 5 (2002), available at http://www.gao.gov/new.items/d02302.pdf (describing workload exceeding available workers since 1995 and also the SECs small salaries compared to other federal agencies, which contribute to very high turnover).
340. See supra note 87 and accompanying text.
341. Congressional Review of Agency Rulemaking Act, 5 U.S.C. §§ 801-808 (2000). "Major rules," that is, rules whose implementation entail substantial costs, cannot take effect during the sixty days afforded Congress to perform its review. See 5 U.S.C. 801(a)(3);
342. cf. EATWEUL & TAYLOR, supra note 78, at 19 (arguing that a balance needs to be struck when examining the benefits and costs of regulation).
343. OFFICE OF MGMT. & BUDGET, EXECUTIVE OFFICE OF THE PRESIDENT, DRAFT 2007 REPORT TO CONGRESS ON THE COSTS AND BENEFITS OF FEDERAL REGULATION 8 (2007) [hereinafter OMB REPORT].
344. Id. The analysis regarding health and safety regulations is often context-specific. Compare ENVTL. PROTECTION AGENCY, EPA-452/R-05-003:
345. REGULATORY IMPACT ANALYSIS OF THE FINAL CLEAN AIR MERCURY RULE § 1 at 1, § 12 at 1 (2005) (balancing the cost to a state of implementing the cap-and-trade system against the ultimate health effects in humans-that is, morbidity, infant mortality, and such welfare effects as visibility improvements-of lowering the level of mercury that is consumed) with OMB REPORT,
346. supra note 264, at 62 (citing Occupational Exposure to Hexavalent Chromium, 71 Fed. Reg. 10100 (Feb. 28, 2006) (codified at 29 C.F.R. pts. 1910, 1915, 1917-18, & 1926)) (balancing the benefits of preventing 40 to 145 fatal and 5 to 20 non-fatal lung cancers per year against OSHA's estimated annual compliance costs of installing engineering controls and the purchase and use of supplemental respirators at the new Permissible Exposure Limit ($36-896 billion/year versus $244-253 million/year as monetized by the OMB)).
347. OMB REPORT, supra note 264, at 8-9. In either event, in assessing costs and benefits, regulators often view an industry in isolation and ask what would have happened absent the regulation. Robert W. Hahn & John A. Hird, The Costs and Benefits of Regulation: Review and Synthesis, 8 YALE J. ON REG. 233, 239-40 (1991) (referring to this as the "partial equilibrium model"). To the extent regulation deals exclusively with economics, agencies will create econometric models based on the supply and demand characteristics of the industry before and after a regulatory change. Id.
348. See supra notes 70-71 and accompanying text.
349. This type of regulation is discussed in Cass R. Sunstein, Irreversible and Catastrophic, 91 CORNELL L. REV. 841, 848 (2006). A precautionary principle is most often used when assessing the impact of human actions on complex systems, such as the environment and human health, where the consequences of actions may be unpredictable. JAMES SALZMAN & BARTON H. THOMPSON, JR., ENVIRONMENTAL LAW AND POLICY 16 (2d ed. 2007);
350. Robert G. Chambers & Tigran A. Melkonyan, Pareto Optimal Trade in an Uncertain World: GMOs and the Precautionary Principle, 89 AM. J. AGRIC. ECON. 520, 528 (2007).
351. Although this principle is often explicitly mentioned in international environmental regulations, it also is implicit in such domestic regulation as efforts to prevent terrorist attacks or regulation of the nuclear power industry, where high costs are justified even in the face of uncertain risk.
352. See Cass R. Sunstein, Beyond the Precautionary Principle, 151 U. PA. L. REV. 1003, 1005-07 (2003).
353. Id. at 1017-18. Governments have incorporated this principle into regulatory policies, and the European Commission has urged that the precautionary principle be considered within a structured approach to the analysis of risk. Id.
354. Under a stronger version of the precautionary principle, when an activity is shown to present a significant health or safety risk, regulatory decisions should be made so as to prevent the activity from being conducted notwithstanding scientific uncertainty as to the nature of the damage or the likelihood of its occurrence. Sunstein, supra note 268, at 849. This stronger version, however, offers little practical guidance to regulators. Sunstein, supra note 269, at 1017-18;
355. see also JOHN D. GRAHAM & JONATHAN B. WIENER, RISK VS. RISK (1995) (demonstrating that interventions to reduce one risk may induce new countervailing risks); Jonathan B. Wiener, Precaution in a Multi-Risk World, in HUMAN AND ECOLOGICAL RISK ASSESSMENT: THEORY AND PRACTICE 1509 (Dennis D. Paustenbach ed., 2002) (arguing that although "precaution" can be a desirable strategy in some cases, strong versions of the precautionary principle can induce unintended countervailing risks, that the goal should be optimal rather than maximal precaution, and that actual regulation often moderates the degree of precaution in order to avoid these unintended risks).
356. Sunstein, supra note 269, at 1017-18.
357. See supra note 70 and accompanying text.
358. Discounting the consequences of a risk by the probability of its occurring is sometimes referred to mathematically as R = p(X), where R = risk, p = probability, and X = severity.
359. For examples of expected-value analysis, see POSNER, supra note 34, § 15.1, at 445 & n.l.
360. Memorandum from E. Bruce Leonard, President, Int'l Insolvency Inst., to All Institute Members 2 (June 16, 2006) (on file with author) (discussing the prediction of a "25% probability within two years of a significant disruption in the international financial markets, probably attributable to the collapse or serious difficulties of a major hedge fund," as one of the "highlights from the Conference").
361. Because the 25% probability of systemic risk absent regulation is a two-year estimate, the other values used in these equations will be based on two-year estimates. The applicable time period chosen is irrelevant so long as it is common for all values, because these equations are being used solely for comparative purposes.
362. LOWENSTEIN, supra note 36, at 190.
363. Cf. David Henry & Matthew Goldstein, The Bear Flu: How It Spread, BUS. WK., Jan. 7, 2008, at 30, 32 (suggesting that, globally, the "tab from the [subprime] mortgage mess could run up to $500 billion");
364. Postcards from the Ledge, ECONOMIST, Dec. 19, 2007 (estimating that, in the United States, "[s]ubprime borrowers will probably default on $200 billion-300 billion of mortgages");
365. Tightening the Safety Belt, ECONOMIST, Nov. 22, 2007 (graph showing Goldman Sachs prediction of $148 billion of losses on subprime CDOs).
366. The term "biannually" is used here to mean every two years. See supra note 277.
367. BOOKSTABER, supra note 139, at 257 (arguing that regulation will not help if there is a failure to understand the mechanisms by which crises develop).
368. Indeed, R might even represent a profit, not a cost, if liquidity is provided to markets by purchasing securities at a deep discount.
369. See supra note 268 and accompanying text.
370. Cf. Bernanke, supra note 6 (observing that if hedge funds were forced to reduce exposures in terms of liquidity risk, "liquidity in a particular market segment could decline sharply and unexpectedly").
371. See supra note 78 and accompanying text; infra note 314 and accompanying text.
372. See supra section II.B.
373. See supra section II.B.
374. 1.
375. See supra notes 248-61 and accompanying text.
376. See supra notes 236-41 and accompanying text.
377. See supra notes 236-41 and accompanying text.
378. See supra notes 236-41 and accompanying text.
379. See supra notes 186-88 and accompanying text.
380. See SEC, REPORT AND RECOMMENDATIONS PURSUANT TO SECTION 401(C) OF THE SARBANES-OXLEY ACT OF 2002 ON ARRANGEMENTS WITH OFF-BALANCE SHEET IMPLICATIONS, SPECIAL PURPOSE ENTITIES, AND TRANSPARENCY OF FILINGS BY ISSUERS 3 (2005) (recommending that "transactions and transaction structures primarily motivated by accounting and reporting concerns, rather than economics[,]" be discouraged in the future through a combination of changes to accounting standards by the Financial Accounting Standards Board (FASB) and greater awareness by participants in the financial reporting process).
381. The other way is to impose entity-level liquidity requirements. See supra note 235 and accompanying text.
382. See supra notes 203, 227 and accompanying text.
383. See supra notes 225-29 and accompanying text.
384. See supra notes 202-30 and accompanying text.
385. See supra notes 281-83 and accompanying text.
386. See supra note 279 and accompanying text.
387. 1.
388. 2 = × $M + R = 0.05 X $5,000,000,000 + $1,000,000,000 = $1,250,000,000.
389. Some estimates of M could nonetheless reach sufficiently high levels to justify regulatory approaches such as reducing leverage. Consider, for example, a systemic-risk doomsday scenario along the lines of the Great Depression. From its peak in 1929, to its cyclical nadir in 1933, the U.S. gross domestic product (GDP) shrank 45.6% as a result of that Depression. GDP and Other Major NIPA Series, 1929-2006: II, SURV. CURRENT BUS., Aug. 2006, at 169,169, available at http://www.bea.gov/ scb/pdf/2006/08August/0806-GDP-NIPAs.pdf. If a systemic meltdown of equal consequence hit the United States today, the GDP would shrink (using a GDP of $13.19 trillion, the most recent figure available) by-and thus M would equal-$6.06 trillion.
390. See id. at 173. This Article does not suggest that M is likely to be anywhere near that order of magnitude.
391. See supra notes 203, 296 and accompanying text.
392. This biannual value for R appears reasonable given that the much more complex effort of implementing the Basel II regulatory measures is estimated by the U.S. Office of Management and Budget to cost, in total over four years, only $545.9 million (present value). OMB Report, supra note 264, at 56.
393. 2 = 0.10 × $2,000,000,000 + $100,000,000 = $300,000,000.
394. 2 = 0.10 × $5,000,000,000 + $100,000,000 = $600,000,000.
395. 2 = $250,000,000, making regulation highly efficient.
396. See supra notes 203-06 and accompanying text.
397. See supra notes 222-35 and accompanying text.
398. See Frederic S. Mishkin, Financial Consolidation: Dangers and Opportunities, 23 J. BANKING & FIN. 675, 683 (1999). For this policy to be credible, however, the liquidity-provider of last resort might sometimes have to let a critical financial intermediary fail. Marvin Goodfriend &
399. Jeffrey M. Lacker, Limited Commitment and Central Bank Lending, ECON. Q., Fall 1999, at 19-20.
400. See supra notes 224-30 and accompanying text.
401. See supra note 120 and accompanying text.
402. See supra notes 205-09, 222-25 and accompanying text.
403. Calculating these discounts, however, admittedly might sometimes be difficult. See supra note 226 and accompanying text.
404. See supra notes 245-48 and accompanying text. "Effective market discipline can be achieved when market participants including investors, financial intermediaries, and policymakers receive timely, reliable, and relevant information."
405. ZABIHOLLAH REZAEE, FINANCIAL INSTITUTIONS, VALUATIONS, MERGERS, AND ACQUISITIONS: THE FAIR VALUE APPROACH 118 (2001). At least one observer has argued that current market discipline standards have been "undermined by the provision of . . . publicly supplied credit guarantees, which relieve debtors from risk, thereby creating both debtor and creditor moral hazards." Hal S. Scott, Market Discipline for Financial Institutions and Sovereigns, in MARKET DISCIPLINE ACROSS COUNTRIES AND INDUSTRIES 69 (Claudio Borio et al. eds., 2004). It has been urged that "the effectiveness of market discipline as a line of defense against . . . systemic risk needs to be enhanced . . . [in] areas where it is obvious that transparency and disclosure are insufficient for the exercise of effective market discipline." Garry Schinasi, Remarks on Causes and Conditions of Financial Instability Panel, in INTERNATIONAL FINANCIAL INSTABILITY: GLOBAL BANKING AND NATIONAL REGULATION 177 (Douglas D. Evanoff et al. eds., 2007). Observers posit that these areas include "large complex financial institutions; global over-the-counter derivatives markets; and hedge funds and other financial institutions or hybrids that fall outside the scope of existing radar screens." Id.
406. Market discipline is a prophylactic regulatory approach, and a liquidity-provider of last resort acts prophylactically to prevent a collapse. But the primary goal of a liquidity-provider of last resort is reactive-to mitigate the spread and consequences of systemic collapse-and ad hoc approaches are, by definition, purely reactive.
407. See supra notes 140-42 and accompanying text.
408. See, e.g., Michele Fratianni & John Pattison, International Financial Architecture and International Financial Standards, 579 ANNALS AM. ACAD. POL. & SOC. SCI. 183, 184 (2002) (observing increasing concern over transmission internationally of local financial failures);
409. Michael Ehrmann & Marcel Fratzscher, Global Financial Transmission of Monetary Policy Shocks 26-27 (Eur. Cen. Bank, Working Paper No. 616, 2006) (showing that U.S. monetary shocks have a significant effect on foreign stock markets, and that the more financially integrated countries are, the greater the effect of a monetary shock in one country on such other countries).
410. RAHUL DHUMALE ET AL., GLOBAL GOVERNANCE OF FINANCIAL SYSTEMS: THE INTERNATIONAL REGULATION OF SYSTEMIC RISK 20, 82 (2006) (noting that the Bretton Woods system received its name from its founding conference in Bretton Woods, New Hampshire, in 1944 and comprised several agreements among economic planners to "rebuild the global economic order"). These agreements also established the IMF and the International Bank for Reconstruction and Development ("World Bank"). Id.
411. EATWELL & TAYLOR, supra note 78, at 1. Nations entrusted gold as an international medium of exchange because of its earlier use under the gold standard, and they accepted the dollar as an international currency because the United States had accumulated significant quantities of gold. CAMPBELL R. MCCONNELL & STANLEY L. BRUE, ECONOMICS: PRINCIPLES, PROBLEMS, AND POLICIES 724 (16th ed. 2005). They therefore came to accept gold and the dollar as international reserves, with the dollar convertible into gold on demand. Id.
412. EATWELL & TAYLOR, supra note 78, at 1.
413. Robert Guttman, The International Monetary System, in REFORMING MONEY AND FINANCE: TOWARD A NEW MONETARY REGIME 14-15 (Robert Guttman ed., 2d ed. 1997).
414. MCCONNELL & BRUE, supra note 321, at 724. This in turn made it increasingly doubtful that the United States would be able to continue to convert dollars into gold at $35 dollars per ounce, or that dollars would continue to function as instruments of international monetary reserves. Id.
415. EATWELL & TAYLOR, supra note 78, at 1.
416. Id. at 1-3; DHUMALE ET AL., supra note 320, at 14.
417. See, e.g., Timothy A. Canova, The Transformation of U.S. Banking and Finance: From Regulated Competition to Free-Market Receivership, 60 BROOK. L. REV. 1295, 1354 n.76 (1995) (noting that in the early 1990s, the U.S. Treasury Department unequivocally endorsed financial liberalization by "regularly pressuring other nations to free their domestic interest rates and divorce central bank policy from democratic and parliamentary political control");
418. Alan Friedman, But Nations Appear Reluctant: IMF Pushing To Open East Asian Markets, INT'L HERALD TRIB. (Fr.), Sept. 20, 1997, at 13 (quoting a top IMF official as claiming "the benefits of liberalizing . . . outweigh the potential costs" and a former WTO chief as asserting that financial-services liberalization was "the cure, not the cause" of the East-Asian economic crisis of 1997).
419. GERARD CAPRIO ET AL., FINANCIAL LIBERALIZATION: HOW FAR, HOW FAST? 15-17 (2001) (observing that the liberalized financial markets "laid bare the previous inefficiencies and failures in credit allocation" and undermined efforts to valuate the true value of bank capital and the true risk of bank portfolios);
420. Jayati Ghosh, The Economic and Social Effects of Financial Liberalization: A Primer for Developing Countries 9 (U.N. Dep't of Econ. & Soc. Affairs, Working Paper No. 4, 2005), available at http://www.un.org/esa/desa/papers/2005/wp4-2005.pdf ("[F]inancial liberalization creates exposure to the following kinds of risk: a propensity to financial crises, both external and internal; a deflationary impact on real economic activity and reduced access to funds for small-scale producers, both urban and rural. This in rum has major social effects in terms of loss of employment and more volatile material conditions for most citizens."); see also EATWELL & TAYLOR, supra note 78, at ix ("The presumption, widely held before 1997, that financial liberalization is invariably beneficial, has now been abandoned by almost all serious commentators.").
421. DHUMALE ET AL., supra note 320, at 14.
422. See Elene Spanakos, Note, Harmonization of International Adequacy Rules for Securities Firms: An Argument To Implement the Value at Risk Approach by Adopting Basel's Internal Model Methodology, 26 BROOK. J. INT'L L. 221, 241-42, 244 (2000) (arguing that without international standards there will be a "race to the bottom" in regulatory schemes).
423. See, e.g., JAMES A. HANSON ET AL., GLOBALIZATION AND NATIONAL FINANCIAL SYSTEMS 273-74 (2003);
424. David T. Llewellyn, Institutional Structure of Financial Regulation and Supervision: The Basic Issues 7, Paper Presented at a World Bank Seminar (June 6-7, 2006), available at http://info.worldbank.org/etools/library/ latestversion.asp?232743 ("It is an illusion to believe that there is a single, superior model of institutional structure that is applicable to all countries.").
425. Llewellyn, supra note 331, at 7, 10-11.
426. HANSON ET AL., supra note 331 (arguing that the pervasive looting of newly privatized entities in Central and Eastern Europe and the subsequent collapse of small country capital markets in places like Slovakia evidence the challenges inherent in broad and sudden changes to a financial system's regulatory structure);
427. accord DAVID F. GOOD, ECONOMIC TRANSFORMATIONS IN EAST AND CENTRAL EUROPE: LEGACIES FROM THE PAST AND POLITICS FOR THE FUTURE 3-4 (1994) (evaluating the concerns and future of European-wide economic integration and claiming that Central and Eastern European economies have long been characterized by their "economic backwardness").
428. See, e.g., RICHARD J. HERRING & ROBERT E. LITAN, FINANCIAL REGULATION IN THE GLOBAL ECONOMY 120-23 (1994) (suggesting systemic risk is analogous to epidemiological risk, in that both can be effectively resolved by international collaboration when "countries agree[] on how to act . . . [and their] cooperation advance[s] to the point of establishing an international agency and jointly financing international action to control and attempt to eradicate" the contagion); James D. Fearon, Bargaining, Enforcement, and International Cooperation, 52 INT'L ORG. 269, 271 (1998) ("Whether the goal is to control arms racing, reduce the risk of preemptive war, limit global environmental damage, stabilize exchange rates, or reduce protectionism in trade, state leaders . . . coordinate state policies and the actions of the relevant state bureaucracies . . . to gain various benefits of cooperating. ");
429. Edward J. Kane, Government Officials as a Source of Systemic Risk in International Financial Markets, in REGULATING I NTERNATIONAL FINANCIAL MARKETS: ISSUES AND POLICIES 257-58 (Franklin R. Edwards & Hugh T. Patrick eds., 1992) (analogizing the global financial system to the interconnected subsystems of the human body and implying that just as the central immune system is the most efficient way to regulate the health of the body's many subsystems, so is a universal regulatory approach the most efficient means of regulating systemic financial risk).
430. See DAVIS, supra note 18, at 269 (arguing against possible "excessive readiness to assume that the current domestic situation is unique");
431. HUMALE ET AL., supra note 320, at 270 (proposing the establishment of a Global Financial Governance Council to coordinate "effective international financial regulation . . . [using] a multilateral treaty regime that combines legally binding principles of efficient regulation (i.e., capital adequacy and consolidated supervision) and a mechanism for developing nonbinding soft law codes (capital adequacy formulas and coordination of enforcement)");
432. Benn Steil, Regulatory Foundations for Global Capital Markets, in FINANCE AND THE INTERNATIONAL ECONOMY 66 (Richard O'Brien ed., 1992) ("Since any systemic effects of inadequate or misguided regulation in one jurisdiction cannot be contained within that single jurisdiction, the imposition of universal standards or modes of operation is likely to be the only effective response.").
433. See IOANNIS S. AKKIZIDIS & VIVIANNE BOUCHEREAU, GUIDE TO OPTIMAL OPERATIONAL RISK AND BASEL II, 99-105 (2006);
434. Press Release, Bank for Int'l Settlements, Basel n and Financial Institution Resiliency (June 27, 2007), available at http://www.bis.org/press/ p070627.htm.
435. Karen Krebsbach, International-Rule Adoption May Harm Emerging Economies, U.S. BANKER, Apr. 2007, at 22 ("Already more than 100 countries have stated intentions to implement the Basel Capital Accord, known as Basel n."); Memorandum from the Cent. Bank of Bahr., Basel II Update (First Quarter, 2007), available at http://www.cbb.gov.bh/cmsrule/ media/pdf/policydevelopment/Consultations/Basel-II-Update-Ql-2007.pdf ("Over 100 countries are committed to the implementation of Basel II, with implementation dates ranging from 2005 to 2010."). The chairman of Basel II concedes, however, that implementing the accord will be extremely difficult. Peter Norman, Basel II Chairman Says Rules Will Be Hard To Implement, FIN. TIMES (London), Apr. 11, 2005, at 23. Some also argue that Basel II may actually prove counterproductive.
436. See, e.g., DHUMALE ET AL., supra note 320, at 263 (arguing that because the majority of developed nations will adopt some variation of Basel II, the G10 countries are likely to exert at least moderate pressure on developing nations to permit foreign banks to operate in their markets under Basel II, which in turn could have a disproportionate impact on the composition of credit risk in those jurisdictions and place foreign banks at a distinct advantage over local banks).
437. See supra notes 206-08 and accompanying text.
438. ROBERT KELEHER, JOINT ECON. COMM., AN INTERNATIONAL LENDER OF LAST RESORT, THE IMF, AND THE FEDERAL RESERVE 178 (1999). Although the European Central Bank was not in contention when the above comparison was made, the European Central Bank is closely analogous to the Federal Reserve for purposes of such comparison because both are central banks and able to print money as needed.
439. Id. (arguing that the Federal Reserve Bank "has international reserve or money-creating powers and, accordingly, can act to satisfy increased demands for liquidity [and also] can act to create liquidity quickly via open market operations rather than through the slower, more cumbersome discount window mechanism," but tying this argument in part to the U.S. dollar being the dominant reserve currency).
440. Id. at 7 ("[The IMF] cannot create reserves or international money, cannot act quickly enough to serve as an international LOLR, and does not operate in a transparent manner. Further, IMF lending currendy (indirecdy) serves to bail out insolvent institutions, something wholly inappropriate for an international LOLR.").
441. Knedlik, supra note 204, at 26 (describing the IMF's substantial access to capital from more than 20 member states).
442. Id. at 8 ("In the case of a global crisis . . . almost unlimited reserves would be necessary.").
443. Id. at 26 (discussing how the IMF could obtain "quantitatively unlimited" access to member-state funds).
444. Bear Stearns, for example, did not collapse because of problems with economic fundamentals but because of falling prices of mortgage-backed securities that required it to mark-down the value of those securities, which in turn created fear among its contractual counterparties who then refused to have further dealings.
445. See Caveat Counterparty: When Banks Cannot Trust Each Other, ECONOMIST, Mar. 19, 2008, at 86; Andrew Tanzer, Bear Stearns: Tip of the Iceberg, KIPUNGER'S, Mar. 14, 2008, http://www.kiplmger.corn/ columns/picks/archive/2008/pick0314.htm.
446. Systemic Risk Hearing, supra note 1, at 27.
447. See, e.g., BOOKSTABER, supra note 139, at 255-57;
448. see also Yamaguchi, supra note 7, at 3 (observing that even the best preventative measures may not succeed in removing the sources of systemic risk in an environment where financial intermediation evolves at a speed faster than one can anticipate).
449. This type of ex post market-collapse injection of liquidity does not appear to be as desirable as the earlier application recommended by this Article. Once a market has collapsed, not only will the consequences of that collapse be felt, but the liquidity-provider of last resort will also have to raise market prices rather than merely stabilize them, potentially requiring a greater outlay of funds.
450. See supra note 197 and accompanying text.
451. Cf. supra note 55.
452. Giles & Guha, supra note 225.
453. See Giles, supra note 226.