Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Hard to act against systemic risk

Richard Bookstaber says in an interview yesterday that it is not difficult to detect systemic risk – the hard part is to take useful action against it:

But I don’t think systemic risk is hard; at least monitoring systemic risk is not difficult. Nobody can hide risk of that magnitude. It’s there to be seen. As I already mentioned, it is taking action that is difficult.

I entirely agree with this assessment. For example, in Indian banking (and many other parts of the financial sector), it is not at all difficult to see that infrastructure finance is a big systemic risk:

  • There is a large amount of it.
  • There are huge maturity mismatches.
  • Infrastructure as the ultimate non tradeable is a bet on the growth of the Indian economy.
  • Many of the instruments and techniques are new and many lenders have little prior experience with the sector.
  • The central bank has been willing to bend the rules to facilitate expansion of credit to this sector.
  • Infrastructure in India is closely bound up with real estate which is implicated in most banking crises.
  • No individual bank has any incentive to worry about it because it can count on a bail out – infrastructure is too large and strategically important to be allowed to fail.

In short, it is the classic tail risk mitigated by the high likelihood of a sovereign bailout. It is simply not in the interest of anybody (lender, borrower, regulator or government) to do anything about it.

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