INET: Controlling Systemic Risk
Speaking at King’s College, Cambridge University, Professor Ed Kane, of Boston College, discusses the political economy of controlling systemic risk.
He argues that it is necessary to properly define systemic risk if we are to understand it correctly, and that the common official definition (the potential for substantial spillover of institutional defaults from financial sector to real economy) leaves out a crucial element – the endogenous role that safety net subsidies to serious risk taking play in incentivizing firms to take action politically and economically to attain and strengthen their status as systemically important firms. But systemically important firms are really, simply, firms that are administratively, politically, and economically difficult to fail and unwind.
He describes the incentive conflicts that feed the short-term oriented decisions that lead central banks to rescue these companies from the consequences of their aggressive risk-management, and how the resulting costs of the failures fall on taxpayers.