Regulators may be adding to Systemic Risk

ONiell1 141Regulators may be adding to Systemic Risk by John O'Neill

A report from researchers at the Systemic Risk Centre (SRC) at the London School of Economics warns that tighter bank regulation may end up destabilising financial markets and trigger a larger crisis than the 2008 crash.

Financial institutions have been made to adopt the same models to forecast risk, which the report’s authors said relied on the false belief “that there is one knowable and correct model” to foresee the future.

The SRC highlighted the introduction of Basel III risk rules as one area where regulators may actually be making finance more dangerous. Analysis has found that models introduced under Basel III “less accurately measured and forecast” risk than under the previous Basel II regime. The SRC cautioned regulators against falling prey to the “fallacy of composition”, assuming that because individuals components of the financial system have been made safe, that the whole too would be stable.

If all institutions are forced to use a homogenous risk model, then they might all suffer in the same way at the same time. In an attempt to make every market participant act more safely, the authorities will make the market as a whole far more dangerous, the report warned. LSE professors Jon Danielsson and Jean-Pierre Zigrand said: “While it is not possible to eliminate systemic risk or the incidence of crises entirely, the objective should be a more resilient financial system that is less prone to disastrous crises while still delivering benefits for wider society.”