I will begin by explaining the issue of systemic risk in a little more detail, taking the recent crisis as my example, and making it clear why regulatory interventions in the financial system are necessary. On the basis of these explanations, I will then present the key criteria, which, in my opinion, should be used as guidelines when designing regulatory measures. In other words, I will be sketching the core components of a kind of roadmap for containing systemic risk. However, since we can never rule out the emergence of a new crisis, we also require a well-placed safety net. This will help to secure an adequate supply of liquidity to banks and markets, even at times of increased stress. A final section will be dedicated to this area, with some remarks on the importance of the central banks’ function as lender of last resort. Systemic risk and the financial crisis Normally a number of different factors are simultaneously responsible for the accumulation of systemic risk over time leading to a crisis – as happened in the recent crisis. A number of well-known examples of possible risk factors and undesirable developments in the financial system include irrational market developments (e.g. bubbles during the upswing or fire sales during the downswing), inadequate or inappropriate regulation (e.g. weak points in Basel II), excessive confidence in markets and models (e.g. VaR), false incentive systems (such as implicit state guarantees for systemically important banks), and complex and intransparent products (e.g. complex securitised loans).
The first important criterion is whether the measures that are taken can reduce the social costs that can arise as a result of systemic risk. Ultimately, what is needed is an internalisation of the negative externalities, so that market discipline and market order are restored. The TBTF issue, in particular, is an illustration of the fact that the market’s power to impose sanctions is not fully functioning at present, since systemically important banks  1  For instance, information contagion, interdependences (interbank market) non-substitutability of systemically important functions, etc. 2  BIS Review 146/2010  cannot currently fail. On the contrary, they benefit from a government rescue guarantee for the very reason that, because of their systemic importance, their failure costs would be so high. Thus, at present, TBTF financial institutions are not obliged to bear the full extent of the risk they assume. In the event of problems they can pass on the risk to the general public. This is a fundamental contradiction to the basic principles of a properly functioning market economy. In order to contain these market imperfections the guiding principle should be – do what is necessary, but no more than is necessary! Consequently, the measures to be taken need to contribute to stability without obstructing key welfare-enhancing functions of the financial system.