The Missing Link From Geithner’s Proposed Legislation

Look, at least Timothy Geithner and his colleagues recognize that systemic risk poses too grave a threat to the US economy and must be reined in.

The “how” of that effort is somewhat lacking though. The legislation proposed by Treasury is missing one crucial element: a definition of systemic risk. Yes, I guess “you know it when you see it” might work, possibly. Obviously, that’s not the best approach. I don’t see how anyone in Congress could vote for the Treasury’s legislation as proposed without a clear understanding of a) what the Treasury thinks is systemic risk; b) what is a hard-and-fast definition of an institution that poses systemic risk to the US economy, and not just because that company faces bankrupcty; and c) what the Treasury is planning to do before the fact to minimize systemic risk, because there is nothing in the proposed legislation that talks about preventative measures (and having legislation on the books as a deterrent does not provide enough prevention).

As readers of this blog know, my friend Boaz Salik and I advocate a market-driven definition of systemic risk based on the concept of “disorderly liquidation.” To sum it up, if a company poses such a concentration of assets — say, credit-default swaps — that their liquidation would cause a crash of that marketplace, assuming the market is of a certain size, that holding would be considered a systemic risk and regulators could either force asset liquidations or “penalize” the assets’ holder through mark-to-market accounting. (You can read more about our plan here.)

It is very nice that the Treasury is trying to figure out a plan for addressing a concentration of systemic risk. How about a plan to avoid it in the first place?