Global Catastrophic Risk in 2013

The subject of global catastrophic risk comes up more and more. Have you noticed? If not, here's something to check out.

This isn't some survivalist talking about hiding in a cave somewhere stocked with freeze-dried food and an arsenal of guns n' ammo. It's an IMF paper that analyzes a very real problem. The paper identifies the source of the problem and quantifies the problem. It's about as specific as you can get.

Here's a quick excerpt:

The global derivatives markets in the post Lehman period...are unstable and they can bring about catastrophic failure.

Clear enough?

Quite simply, a threat of failure to any of the SIFIs is an immediate threat to the others. The network topology where the very high percentage of exposures is concentrated among a few highly interconnected banks implies that they will stand and fall together. This topological fragility of the derivatives markets as risk sharing institutions has an implicit moral hazard problem that undermines their social usefulness.

Maybe a little less clear, so here's what it says:

If any SIFI (Systemically Important Financial Institution) fails, all the others will go down with it. "Network topology" refers to the authors' use of analysis that shows the nature of the connections between the players in the derivatives market. These connections show that the SIFIs - the institutions which are the biggest players in this market - are intimately connected, hence the authors' view that the failure of one will mean the failure of all. The authors also question how useful the derivatives market will prove to be as a mechanism to reduce risk, given the fragility of the system, and the fact that, in the end, the taxpayer will be called on to bail out the system when bailouts become necessary to avoid complete collapse.

(Read the whole article by clicking HERE.)

They do present a solution: a "tax" on these SIFIs. The authors quantify how much money these institutions need to contribute to some sort of escrow account in order to provide the liquidity needed to avoid complete collapse if one of the institutions fails. But note that this is simply an idea concocted by the authors. These institutions do not post any capital in reserve in such an account at this time. Will they? I don't know. The authors choose to refer to their suggestion of posting capital as "good news." I suppose it might be if the money were actually placed into this safety account. 

Maybe regulators will require these institutions to do this. But if you believe they will, then you need to read a cover story on today's Wall Street Journal.

...Global banking regulators watered down a key element of their plan for creating a safer financial system...

More...

You can draw your own conclusions after reading this. Welcome to 2013.