Abstract

Paper prepared for "Zeitschrift für Wirtschaftspolitik" Forum theme on "Lessons from the financial crisis: On the need to change financial market rules to limit systematic risks" ("Lehren aus der Krise. Notwendige Änderungen der Finanzmarktregeln und zur Begrenzung systemischer Risiken"). Introduction The need to contain "systemic risk" originated by the activity of financial actors has historically been one of the primary rationales for the public intervention in the regulation of financial markets. It was in particular the experience of the banking failures of the 1930s that paved the way to an increase in the involvement of governments in the design of a large array of regulatory tools to mitigate the risk associated with banking crises. However, the definition of what financial activities and institutions generate systemic risk -and therefore what should be object of regulation -has changed radically over time. Major episodes of financial instability have usually been the trigger challenging the dominant understandings of the sources of systemic risk. The latest crisis started in the summer of 2007 has been no exception. This paper discusses how this crisis urges analysts and regulators to rethink the origin of systemic risk in the financial system. Three key lessons can be distilled from the debates triggered by the crisis. First, a focus uniquely on the banking sector misses how systemic risk is originated by a wider range of markets, instruments, and institutions that have become "systemically important". Second, the sources of systemic risk go beyond the "too big to fail problem", but they involve also other factors such as the degree of interconnectedness, leverage, maturity mismatches and common exposures. Third, systemic risk cannot be contained simply by ensuring the stability of individual institutions, but this must be complemented by a macro-prudential approach to financial regulation. In the second part of the paper we discuss how these lessons should inform the regulatory response. Our analysis focuses in particular on two regulatory principles: comprehensiveness and countercyclicality.