This post is an excerpt from a presentation I made in Winston-Salem, NC on Saturday, September 11, 2010.  The presentation slides will be available shortly at www.stalkingtheblackswan.com

The problem with financial crises is that financial firms are so interconnected:  the failure of one firm may unleash an unpredictable cascade of defaults at other firms, risking a severe economic downturn.  Even the possibility of failure is enough to freeze the capital markets, as investors brace for the next domino to fall, and then the next after that.  No surprise that regulators step in to bail out financial firms when they start to wobble.  Costly and unpopular, yes, but bail-outs are better than risking the collapse of the financial system under a wave of defaults (as we saw with the decision to let Lehman fail).

There is a better way.  The Dodd-Frank Financial Reform bill contains important provisions that establish a Financial Stability Oversight Council, which will be supported by a new treasury department, the Office of Financial Research, and gives these entities significant budgetary resources and legal powers. 

In a nutshell, the bill has created a kind of “air traffic controller” for the financial system – a function that historically has been lacking.

Traditionally, financial regulators have supervised individual financial firms.  Supervisors make sure each financial firm has adequate capital and follows sensible policies.   In this way, they act much like the Federal Aviation Administration (FAA), which takes steps to ensure that aircraft are properly maintained and safe to operate.  Without air traffic controllers, however, two perfectly safe aircraft could still crash into each other.  Similarly, two financial firms that had passed their regulatory exams could still get into trouble in a crisis, if they had counterparty relationships with other, riskier firms.  Both airplanes and financial firms have “interconnections” that need to be monitored and managed. 

As strange as it may seem, there, there is no financial equivalent of the air traffic controller.  No-one in government systematically monitors interconnections.  That is part of the reason that Fed chairman Bernanke and treasury secretary Paulson struggled during the crisis, bailing out some firms that were obviously systemically important, but missing others (like Lehman).

The Office of Financial Stability Oversight could make a big difference:  instead of supervising individual financial firms, it would study their interconnections.  This would require two steps, which the Dodd-Frank bill delegates to the Office of Financial Research:

·         An information technology system would aggregate real-time data on counterparty exposures from regulated financial institutions and any unregulated firms that regulators think might pose systemic risk.  This information collection need not be burdensome:  the reporting could be programmed into the firms’ own risk-management systems.  Given the large number of firms and interconnections, and the speed with which they change, regulators would never have a complete view.  But any systematic collection of information would be an improvement over the current situation.

·         A judgmental approach in which highly experienced regulators from the Office of Financial Research would visit any financial institutions that caught their attention, interview management, and inspect their transaction records, in order to stay abreast of new trends that the IT systems might not pick up.

The goal of this two-pronged approach would be to identify firms that, because of their interconnections, might pose systemic risk.  For example, had it been in place during the crisis, the Office of Financial Research might have identified AIG as posing systemic risk because several large investment banks depended on it for billions of dollars of insurance against subprime mortgage losses.  Or it might have discovered that money market mutual funds held large amounts of Lehman’s debt.   Or that many banks held preferred stock in Fannie Mae and Freddie Mac.

Firms with these levels of interconnections pose systemic risk because their failure could cause other firms to fail, too.  Regulators should require these firms to hold extra capital for the risk that they pose to the rest of the system.  That requirement would encourage the firms to shrink or reposition their business, to bring the interconnections back under control.  And this would help make the financial system more robust in the face of the next “Black Swan,” whatever and whenever that might happen to be.