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Sunday, September 21, 2008

Dombalagian on Investment Banks & Systemic Risk

'Too Interconnected to Fail?': Investment Banks and Systemic Risk, by Onnig H. Dombalagian, Tulane Law School, was recently posted on SSRN.  Here is the abstract:

I argue that the most efficient way to regulate investment banks for financial responsibility is to make them bear (at least some) of the consequences of a systemic crisis. More prudential oversight is not likely to be helpful, in an age of rigorous risk modeling, and complex federal insolvency regimes (as in the banking industry) are not likely to be tractable for investment banks. The most effective incentive for firms to take a more pro-active role in counterparty and systemic risk management, thus, is to formalize the existing expectation that financial services conglomerates participate (at least, to a degree commensurate with their interest) in the rescue of an insolvent competitor whom the industry deems "too interconnected" to fail. To that end, this Article proposes a self-regulatory framework for top-tier financial holding companies and investment banks both to make such determinations and help shoulder the burden in addressing the consequences.

Congress would enact legislation creating the framework of such an organization, as well as principles for the sharing of information among participating firms, to be implemented by specific rules. The organization would be responsible for identifying risks, determining the flows of information necessary to contain those risks, and building mechanisms to share that information. More importantly, the organization would be expected to participate in the financing (and share in the profits or loss resulting from) any bailout of a member entity, pursuant to rules established by the organization. An industry regulator (similar to the SEC) would be responsible for overseeing rulemaking that establishes procedures for making such determinations and enforcing compliance with those rules. The Federal Reserve Board, meanwhile, would have the authority to monitor the activities of individual member firms, to set the terms for any acquisition of an insolvent member firm within the parameters established by the industry framework, and (at its discretion) to finance or fund a bailout, in part or in whole, if it is determined to be in the public interest.

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