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'Systemic risk' theory gains in stature as way to prevent the next bubble

By Howard Schneider
Tuesday, July 27, 2010; A11

Americans might be counting on the day when home and retirement-fund values start to rise again, but anyone expecting to benefit from a future boom in prices should take note: Economic policymakers around the world are looking for ways to make sure that doesn't happen, or at least not with such intensity that it risks the kind of bust that usually follows.

In studying how to respond to the recent crisis and create a more stable system, central bankers, international officials and others have been focusing on a concept known as "systemic risk." That's the type of falling-domino problem that allowed mortgage defaults in the United States to lock up the global financial system because of the complex connections among banks, investment companies, insurers and other firms around the world.

The phenomenon is not fully understood.

"We sort of know vaguely what systemic risk is and what factors might relate to it. But to argue that it is a well-developed science at this point is overstating the fact," said Raghuram Rajan, a former International Monetary Fund chief economist and author of "Fault Lines," which explored the role of U.S. real estate and credit bubbles in the crisis.

A recent IMF paper described study of the field as "in its infancy." Still, some central bankers and regulators are devising ways to try to control systemic risk, and one of the things they are focusing on is its connection to fast run-ups in the prices of real estate or other investments, or a quick expansion of credit and lending.

When to step in?

Before the recent crisis, regulators assumed that markets with large numbers of people with enough information and the ability to move money freely could assess the risks of different investments and look out for themselves. That thinking guided U.S. policy under then-Federal Reserve Chairman Alan Greenspan, creating the conditions that allowed millions of Americans to buy homes and borrow money under loose credit terms. Sometimes consumers profited if they sold property at the right time, but sometimes they became saddled, along with their bankers, with unaffordable mortgages or houses that declined sharply in value.

But that approach did not adequately account for systemic risk. Policymakers in the United States and Europe and at organizations such as the IMF are discussing how government agencies could best step in when markets appear to get overheated.

It is not easy to tell the difference between a risky "bubble" and a healthy economic expansion, and confusing one for the other could mean slower growth and lost opportunities.

Yet the cost of the recent crisis in terms of lost production and high unemployment has convinced a broad array of officials, regulators and analysts that government should do more to "lean against" markets that are thought to be growing too fast, and in the process try to ensure that the United States, Europe and other key areas don't again surge in an unsustainable way -- or crash in the aftermath.

"The benefits of successfully moderating both phases of the credit and asset price cycle are clearly worth pursuing," the Switzerland-based Bank for International Settlement said in a recent report.

The BIS serves as a grouping of the world's major central banks, including the U.S. Federal Reserve, and is an influential voice in financial regulation.

The current discussion involves some of the basic principles of how markets should work in a post-crisis age. It throws open a range of sensitive questions such as whether the Fed and other central banks should use interest rates or other tools for such actions as restraining home prices that are judged to be rising too fast.

"I think there has been a massive change in the debate," said Andrew Smithers, founder of the London-based Smithers & Co. economic consultancy. "Simply ignoring asset prices is so demonstrably silly that it will not carry on either side of the Atlantic."

Although Fed Chairman Ben S. Bernanke and others speak warily about using interest rates or the other "very blunt" tools of the central bank to address problems in specific parts of the economy, he also has said he remains "open-minded" to the idea.

Other ideas under discussion include imposing higher capital requirements on banks under certain conditions to slow lending, as well as steps such as forcing potential home buyers to make larger down payments -- familiar to Asian regulators who have had to cope with rapid increases in real estate values.

A new bureaucracy

Overheated markets or dangerous levels of credit and borrowing are hardly pressing issues in the current climate, in which concern is centered on keeping a shaky recovery on track in the United States and Europe. But the attention given systemic risk is apparent in the new bureaucracy growing up around it.

The legislation signed into law last week by President Obama includes a Financial Stability Oversight Council, with powers to study and move against possible sources of systemic risk in the United States.

Europe is establishing a European Systemic Risk Board; the BIS has set up a Financial Stability Board to study and make recommendations about the issue; and the IMF has proposed a central role for itself in monitoring systemic risk on a global scale.

In recent papers, both the IMF and the BIS discussed the chance that a wrong policy choice might slow otherwise healthy economic growth. But they also said the depth of the recent downturn showed that central banks and other government agencies need to expand their traditional focus on such issues as inflation and employment, and to be more attuned to controlling systemic risk and ensuring general financial stability.

Central banks in the developed world have learned how to keep prices stable, but "there was a gaping hole in the system," which ignored financial stability concerns, IMF financial counselor Jose Vinals wrote in a recent essay. Although he said central banks need to keep inflation as their chief focus on monetary policy, he also called for "more 'leaning' in good times and the need for 'less cleaning' in bad times once bubbles explode."

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