11/12/07 Draft

**[Systemic Risk]{.smallcaps}** [^1]

Steven L. Schwarcz[^2]

> *Abstract: Governments and international organizations worry
> increasingly about systemic risk, under which the world's financial
> system can collapse like a row of dominoes. There is widespread
> confusion, though, about the causes and even the definition of
> systemic risk, and uncertainty how to control it. This article offers
> a conceptual framework for examining what risks are truly "systemic,"
> what causes those risks, and how, if at all, those risks should be
> regulated. Scholars historically have tended to think of systemic risk
> primarily in terms of financial institutions such as banks. However
> with the growth of disintermediation, in which companies can access
> capital market funding without going through banks or other
> intermediary-institutions, greater focus should be devoted to
> financial markets and the relationship between markets and
> institutions. This perspective reveals that systemic risk results from
> a type of tragedy of the commons in which market participants lack
> sufficient incentive, absent regulation, to limit risk taking in order
> to reduce the systemic danger to others. Law therefore has a role in
> reducing systemic risk.*

[I. Introduction 2](#__RefHeading___Toc172539223)

[II. DEFINING Systemic RISK 6](#__RefHeading___Toc172539224)

[III. REGULATING SYSTEMIC RISK 15](#__RefHeading___Toc172539225)

[A. The Appropriateness of Regulation 15](#__RefHeading___Toc172539226)

[B. Identifying Regulatory Approaches 23](#__RefHeading___Toc172539227)

[C. Assessing Regulatory Approaches 54](#__RefHeading___Toc172539228)

[D. Recommendations 65](#__RefHeading___Toc172539229)

[IV. REGULATION IN AN INTERNATIONAL CONTEXT
68](#__RefHeading___Toc172539230)

[V. CONCLUSIONS 74](#__RefHeading___Toc172539231)

I. Introduction[]{#__RefHeading___Toc172539223 .anchor}

Governments and international organizations are calling for increased
regulation of systemic risk. In the United States, for example, Congress
has begun holding hearings on systemic risk in response to the recent
sub-prime mortgage crisis and its impact on the mortgage-backed
securities and commercial paper markets.[^3] The U.S. Federal Reserve,
the European Central Bank, and other monetary agencies worldwide have
likewise expressed concern about this crisis and its potential systemic
effects.[^4] Governments are also increasingly concerned about the
potential for systemic failure stemming from hedge fund collapses,[^5]
originally raised by the near collapse of Long-Term Capital
Management[^6] and more recently prompted by the unregulated spread of
hedge funds as a favored investment tool.[^7] Financial leaders are also
calling for increased focus on systemic risk that extends past the
traditional, bank-oriented, approach.[^8]

There is, nonetheless, a great deal of confusion about what types of
risk are truly "systemic"---the term meaning "\[o\]f or pertaining to a
system"[^9]---and what types of systemic risk should be regulated. Some
commentators define systemic risk as "the probability that cumulative
losses will occur from an event that ignites a series of successive
losses along a chain of \[financial\] institutions or markets comprising
. . . a system."[^10] Others, however, define it as "the potential for a
modest economic shock to induce substantial volatility in asset prices,
significant reductions in corporate liquidity, potential bankruptcies
and efficiency losses."[^11] Still others define it as "\[t\]he risk
that a default by one market participant will have repercussions on
other participants due to the interlocking nature of financial markets.
For example, Customer A's default in X market may affect Intermediary
B's ability to fulfill its obligations in Markets X, Y, and Z."[^12]

These definitions are inconsistent in several ways. For example, the
trigger event in the first is merely an "event," in the second a "modest
economic shock," and in the third a "default by one market participant."
The consequences of the trigger event are also different, in the first
definition being "a series of successive \[and cumulative\] losses along
a chain of institutions or markets," in the second being "substantial
volatility in asset prices, significant reductions in corporate
liquidity, potential bankruptcies and efficiency losses," and in the
third being merely "repercussions on other \[market or interlocking
market\] participants." There is not even agreement on whether systemic
risk should be defined by reference to market losses or just market
participant losses.[^13] The only common factor in these definitions is
that a trigger event causes a chain of bad economic consequences.

Alan Greenspan has summed up the confusion, observing that although
"\[i\]t is generally agreed that systemic risk represents a propensity
for some sort of financial system disruption\[,\] one observer might use
the term 'market failure' to describe what another would deem to have
been a market outcome that was natural and healthy, even if harsh."[^14]
As a result, the "very definition \[of systemic risk\] is still somewhat
unsettled."[^15]

If a problem cannot be defined, it cannot be solved---or, at least, it
cannot be efficiently solved since confusion over the nature of the
problem can obscure attempts to provide solutions. This article
therefore proceeds, first, by trying to define systemic risk and by
examining what it is about this risk that is most problematic. Building
on that foundation, the article offers a conceptual framework for
solving the problem of systemic risk, focusing on regulatory solutions.
In that context, the article examines how risk itself---in particular,
financial risk---should be regulated and then inquires how that
regulatory framework should change by reason of the financial risk being
systemic. Finally, the article focuses on systemic risk in an
international context since, finance and markets being global, systemic
collapse in one country can affect markets and institutions in other
countries. To this end, the article examines the feasibility of
international regulation, the extent to which regulatory solutions are
universal or should be different for different countries, and the
potential for a regulatory race to the bottom if regulation is done on
only a national level.

A threshold question is whether regulatory solutions are appropriate.
This article argues they are because, like a tragedy of the
commons,[^16] no individual market participant has sufficient incentive,
absent regulation,[^17] to limit its risk taking in order to reduce the
systemic danger to other participants and third parties.[^18]

II\. DEFINING Systemic RISK[]{#__RefHeading___Toc172539224 .anchor}

A common factor in the various definitions of systemic risk is that a
trigger event, such as an economic shock or institutional failure,
causes a chain of bad economic consequences---sometimes referred to as a
domino effect. These consequences could include (a chain of) financial
institution and/or market failures. Less dramatically, these
consequences might include (a chain of) significant losses to financial
institutions or substantial financial-market price volatility. In either
case, the consequences are to financial institutions, markets, or both.

*Financial Institutions:*

Banks and other financial institutions (collectively, "institutions")
are important sources of capital. Therefore their failure, especially in
large numbers, can deprive society of capital and increase its cost.
Increases in the cost of capital, or decreases in its availability, are
the most serious direct consequences of a systemic failure.[^19]

The classic example of systemic risk in this context is a "bank run," in
which the inability of a bank to satisfy withdrawal-demands causes its
failure, in turn causing other banks or their creditors to fail.[^20]
The original failure can occur when depositors panic, converging on the
bank to quickly withdraw their monies. Because banks keep only a small
fraction of their deposits on hand as cash reserves, a bank may have
insufficient cash to pay all withdrawal-demands, causing it to default
and ultimately fail.[^21] The chain of subsequent failures can occur
because banks are closely intertwined financially. They lend to and
borrow from each other, hold deposit balances with each other, and make
payments through the interbank clearing system (whereby banks with
equity and deposit accounts exceeding their liabilities can offer these
excess funds to other banks who wish to increase loans to their
customers).[^22] Because of this interconnectedness, one bank's default
on an obligation to another may adversely affect that other bank's
ability to meet its obligations to yet other banks, and "so on down the
chain of banks and beyond."[^23]

This is most graphically illustrated by the Great Depression.[^24] In
response to the stock market downturn of August 1929 and the crash of
October 1929, depositors en masse attempted to convert their bank
deposits into cash.[^25] Many banks were unable to satisfy all of these
demands, causing them to fail and contracting the money supply.[^26]
These failures, in turn, caused many otherwise solvent banks to
default,[^27] and many companies, deprived of liquidity, were forced
into bankruptcy.[^28] During the height of the Great Depression, from
1930 to 1933, there were approximately 2000 bank failures yearly.[^29]

Although a chain of bank failures remains an important symbol of
systemic risk, the ongoing trend towards disintermediation---or enabling
companies to access the ultimate source of funds, the capital markets,
without going through banks or other financial intermediaries[^30]---is
making these failures less critical than in the past.[^31] Companies
today are able to obtain most of their financing through the capital
markets without the use of intermediaries.[^32] As a result, capital
markets themselves are increasingly central to any examination of
systemic risk.[^33] Systemic disturbances can erupt outside the
international banking system and spread through capital-market linkages,
rather than merely through banking relationships.[^34]

*Markets:*

Under modern finance theory, investors and other market participants can
protect themselves from risk by diversifying their investments. To the
extent risk is negatively correlated, or uncorrelated, with market risk,
the randomly distributed risks of a diversified investment portfolio
"would tend to cancel out, producing a riskless portfolio."[^35] To the
extent systemic risk affects markets, however, it is positively
correlated with the markets and cannot be diversified away.[^36]

The near failure of Long-Term Capital Management ("LTCM") helps to
illustrate the potential for this type of systemic risk. Although LTCM
itself engaged in a diversified (and therefore inherently protective)
hedging strategy, temporary market irrationality in bond pricing during
August 1998, touched off by Russian government default on its bonds,
caused LTCM to lose hundreds of millions of dollars and approach a
default.[^37] The Board of Governors of the U.S. Federal Reserve System
was concerned that LTCM's default might shake confidence in worldwide
financial markets:

> Had Long Term Capital been suddenly put into default, its
> \[derivatives\] counterparties would have immediately "closed out"
> their positions. If counterparties would have been able to close-out
> their positions at existing market prices, losses, if any, would have
> been minimal. However, if many firms had rushed to close-out hundreds
> of billions of dollars in transactions simultaneously, they would have
> been unable to liquidate collateral or establish offsetting positions
> at the previously-existing prices. Markets would have moved sharply
> and losses would have been exaggerated.[^38]

Moreover, as a result of these market moves,

> there was a likelihood that a number of credit and interest rate
> markets would . . . possibly cease to function for a period of one or
> more days and maybe longer. This would have caused a vicious cycle: a
> loss of investor confidence, leading to a rush out of private credits,
> leading to further widening of credit spreads, leading to further
> liquidations of positions, and so on.[^39]

To avoid this scenario from playing out and raising the cost of
capital,[^40] the Federal Reserve proactively stepped in to broker a
workout of LTCM's debts.[^41]

There are overall similarities, however, between bank systemic risk and
the kind of systemic risk represented by LTCM. In both, market shocks
triggered institutional failures which in turn led, or could have led,
to a chain of institutional and market failures. Both also were
transmitted through linkages in a chain of relationships: in bank
systemic risk, the linkages are interbank borrowings and the interbank
clearing system for payments,[^42] in LTCM the linkages arose from its
derivatives-based hedging strategy with other institutions[^43] which,
in turn, had linkages with yet other institutions and markets.

*An Integrated Perspective:*

Institutional systemic risk and market systemic risk should therefore
not be viewed each in isolation. Institutions and markets can be
involved in both. Perhaps a better way to think about systemic risk is
that its focus is sometimes critical financial intermediaries, like
banks, that are pivotal to the funding of companies, and other times
markets and/or institutions, such as hedge funds, that are either not
financial intermediaries or at least not critical financial
intermediaries.

This integrated perspective is useful because a chain of failures of
critical financial intermediaries, by definition, would significantly
affect the availability and cost of capital. These failures, therefore,
implicitly become a proxy for market consequences.[^44] In contrast, a
chain of failures of institutions that are not critical financial
intermediaries could only significantly affect the availability or cost
of capital when those failures are large enough to jeopardize the
viability of capital markets. As disintermediation increases, therefore,
systemic risk should increasingly be viewed by its impact on markets,
not institutions per se.

This perspective also reveals that the business or legal
characterization of any given institution should be far less important,
from the standpoint of systemic risk, than whether such institution is,
in fact, a critical financial intermediary. Hedge funds, for example,
are not critical financial intermediaries since they are not necessarily
pivotal to the funding of companies. The likelihood that systemic risk
would result from LTCM's failure or from the failure of any other hedge
fund therefore depends not on such entity's characterization as a hedge
fund per se but rather on the likelihood that its failure would
jeopardize the viability of capital markets.[^45] Other than their lack
of transparency---making it difficult to publicly determine the size of
hedge fund exposures---there is little inherently unique about hedge
funds from the standpoint of systemic risk.[^46] Equity investors in a
failed hedge fund may lose their investments, but that should not
necessarily raise concerns over systemic risk because those investors
are necessarily wealthy and sophisticated[^47] and, if they are prudent,
the hedge-fund investment will be only part of a diversified investment
portfolio.[^48] Lenders to a failed hedge fund may not be repaid in
full, but this is no different than a company defaulting on its debt,
which is addressed as a regulatory matter through bankruptcy law.
Derivatives counterparties to a failed hedge fund may not be paid if the
derivatives settle in their favor; but this is no different than a
company defaulting on its obligations to derivatives counterparties,
which again is addressed as a regulatory matter through bankruptcy law.
In LTCM, the potential for systemic risk existed not by reason of its
intrinsic status as a hedge fund but by the sheer size of its exposure
to other institutions and market participants.[^49] Size matters.[^50]

This is not to say that hedge funds, as operated in today's market
environment, do not pose greater systemic-risk potential than many other
types of business organizations. They may because of their aggressive
quest for above-market profits and quick returns,[^51] as well as the
possibility of convergence in their investing strategies.[^52] But these
characteristics are not intrinsic to the nature of a hedge fund as a
private and unregistered investment vehicle,[^53] and indeed other types
of business organizations, including private-equity firms and even
ordinary operating companies, can, and sometimes do, engage in
aggressive or converging investment strategies similar to those used by
hedge funds.[^54]

Synthesizing these factors, we can reach a working definition of
systemic risk: the risk that (i) an economic shock such as market or
institutional failure triggers (through a panic or otherwise) either (x)
the failure of a chain of markets or institutions or (y) a chain of
significant losses to financial institutions, (ii) resulting in
increases in the cost of capital or decreases in its availability, often
evidenced by substantial financial-market price volatility.[^55] As
clarified below, this definition of systemic risk will underlie the
analysis in the remainder of this article, including the example used in
Parts III.B and III.C to help identify and assess regulatory
approaches.[^56]

This definition must be clarified in two ways. First, systemic risk
should be distinguished from downturns that are caused by normal market
swings. Although these downturns are sometimes conflated with systemic
risk, they are more appropriately labeled *systematic* risk, meaning
simply risk that cannot be diversified away and, therefore, affects most
if not all market participants.[^57] As regulators call for management
of systemic risk, it is important not to constrain market freedom in
ways that deter systematic risk, which is a potentially healthy
consequence so that markets can achieve equilibrium and avoid excessive
interest rates or periods of inflation.[^58] Second, systemic risk is an
economic, not a political, definition. It should not be used
uncritically as an ex post political label for any large financial
failure or downturn.

III\. REGULATING SYSTEMIC RISK[]{#__RefHeading___Toc172539225 .anchor}

A. [The Appropriateness of
Regulation]{.underline}[]{#__RefHeading___Toc172539226 .anchor}

Whether systemic risk should be regulated can be viewed as a subset of
the question of whether it is appropriate to regulate financial risk.
This article attempts to answer that general question and then examines
how the answer should change by reason of the financial risk being
systemic.

*Regulating Financial Risk:*

The primary if not sole justification for regulating financial risk,
argue scholars,[^59] is maximizing economic efficiency.[^60] Efficiency
is thus the central goal of the U.S. securities laws,[^61] and it
likewise appears to be the central goal of securities laws
worldwide.[^62] It includes maintaining competition, protecting
investors against fraud and other similar abuses, preventing
externalities (or requiring those causing externalities to internalize
their costs), and correcting other market failures.[^63]

Because systemic risk is a form of financial risk, efficiency should be
a central goal in its regulation. Without regulation, the externalities
caused by systemic risk would not be prevented or internalized because
the motivation of market participants "is to protect themselves but not
the system as a whole. . . . No firm . . . has an incentive to limit its
risk taking in order to reduce the danger of contagion for other
firms."[^64] This observation holds true even for banks, which (absent
regulation) will protect themselves but not the stability of the banking
system.[^65] Moreover, even if market participants were able to
collectively act to prevent systemic risk, they might not choose to do
so. This is because the externalities of systemic failure include social
costs that can extend far beyond market participants.[^66] Market
participants thus will not want to internalize those costs and will take
an insufficient amount of care in preventing them.

As a result, there is a type of tragedy of the commons, in which the
benefits of exploiting finite capital resources accrue to individual
market participants, each of whom is motivated to maximize use of the
resource, whereas the costs of exploitation, which affect the real
economy, are distributed among an even wider class of persons.[^67]
Furthermore, behavioral psychology predicts that individual market
participants---by discounting the impact of systemic risk since it is so
rare relative to other market risks, thereby increasing the apparent net
positive expected value of acting selfishly[^68]---may perceive an even
greater mismatch between benefits and costs.[^69]

To minimize the externalities caused by this tragedy of the commons (and
thereby maximize efficiency), regulation of systemic risk appears not
only appropriate but needed.[^70]

*Beyond Economic Efficiency:*

Efficiency, however, should not be the only goal of regulating systemic
risk. Even though systemic risk is a form of financial risk, it stands
apart and should be differentiated from traditional financial risk.
Traditional financial risk focuses on risks *within* the financial
system, and then efficiency should plainly be the central goal. Systemic
risk, though, focuses on risks *to* the financial system.[^71]

This focus reveals that systemic risk transcends economic efficiency per
se. Failure of the financial system can generate social costs in the
form of widespread poverty and unemployment, which in turn can destroy
lives and foster crime.[^72] Although efficiency in a broad sense
includes health and safety, these are sometimes viewed from a regulatory
standpoint as going beyond efficiency.[^73] Protecting health and safety
therefore should be additional goals of regulating systemic risk.

These additional goals can be reduced, however, to the single goal of
preserving stability of the financial system, since preserving stability
would avoid the breakdown that could lead to health and safety concerns.
This approach finds a measure of indirect empirical support in the
report recently issued by the Department of Homeland Security (DHS) in
connection with an anticipated bird-flu pandemic.[^74] DHS has prepared
a list of seventeen industry sectors, including banking and finance,
that might be affected by a pandemic and whose breakdown could have a
debilitating impact on national economic security, public health, and
safety.[^75] In each case, DHS's primary goal is to preserve the
stability of these industry sectors in the face of a pandemic.[^76]

For analysis purposes, the remainder of this article will assume that
preservation of the financial system is socially desirable[^77] and thus
stability should be an important regulatory goal.[^78] The goals of
regulating systemic risk thus should include both efficiency and
stability.[^79]

*Regulatory Costs and "Efficiency":*

These goals can help to identify potential approaches to regulating
systemic risk. Any regulatory regime incorporating these goals should be
carefully crafted, however, because regulation is not costless.[^80]
Indeed, its costs---which are both direct and indirect---can be
high.[^81] The former include the cost of hiring government (or
government-delegated) employees to enforce the regulation as well as
associated monitoring and compliance costs.[^82] The latter include
unintended consequences of regulation, such as moral hazard,[^83] loss
of economic welfare caused by firms performing fewer transactions, and
the dynamic costs of regulations acting as a barrier to innovation.[^84]
For example, government intervention (or bailout loans) to prop up a
failing company can foster moral hazard by making companies take more
risks and investors act less diligently or cautiously.[^85] Regulation
also can disrupt the efficient evolution of markets.[^86]

In identifying regulatory approaches, the discussion below therefore
takes into account not only the goals of stability and efficiency but
also the costs of regulation based on these goals. Although technically
the concept of efficiency already should embody costs, there are two
notions of efficiency at issue here. The first notion concerns
efficiency in the context of systemic risk, which means preventing or
internalizing externalities and correcting market failures.[^87] Because
systemic risk can cause market failures and associated
externalities,[^88] any regulatory approach that reduces systemic
risk---*and thus presumably any of the regulatory approaches identified
below*---will be efficient under that first notion. The discussion below
therefore need not focus on this first notion of efficiency. The second
notion of efficiency concerns the costs of regulation. Because
regulation can be costly, efficiency also demands that the costs of
regulation do not exceed its benefits.[^89] This second notion of
efficiency thus becomes more transparent by separately recognizing those
costs.[^90]

B. [Identifying Regulatory
Approaches]{.underline}[]{#__RefHeading___Toc172539227 .anchor}

To understand how systemic risk should be regulated, it is helpful to
first examine historical approaches.

*Historical Approaches:*

Historically, regulation of systemic risk has focused largely on
preventing bank failure.[^91] For example, federal insurance of bank
deposits through the Federal Deposit Insurance Corporation ("FDIC") is
intended to prevent bank runs by alleviating fear that banks will
default on deposit accounts.[^92] Also, capital adequacy requires banks
to hold minimum levels of capital, a requirement intended to limit
excessive risk taking and viewed as a buffer against financial
crisis.[^93] Recently, the Basel II Capital Accord ("Basel II")
articulated a system of capital holding requirements based on banks'
risk exposures as the first of three regulatory "pillars."[^94]

Even in their limited contexts, these approaches are imperfect. Some
economists argue, for example, that rules preventing bank failure can
cause moral hazard. Banks may increase risk exposures and reduce their
capital ratios, knowing that the safety net will protect against sudden
runs.[^95] And the creation of the FDIC safety net of deposit insurance
removed "a major automatic mechanism by which troubled banks were
previously closed and resolved" when depositors withdrew funds from
insolvent banks.[^96] Deposit insurance also can permit insolvent banks
to remain in operation and continue to generate losses,[^97] such as the
\$150 billion of losses generated by the ongoing operation of insolvent
savings and loan associations.[^98]

Capital requirements are similarly imperfect. Constraining lending
activities of banks can redirect funds to lenders whose constraints are
not binding.[^99] Capital requirements also are said to undercut the
ability of banks to build equity value.[^100] These requirements also
can be imprecise, since the standards by which they are imposed are
imprecise.[^101]

After the near-failure of LTCM, an attempt also has been made to study
how to mitigate systemic risk arising from hedge-fund failure. However
the main government report, spearheaded by the Federal Reserve Board,
provided only general recommendations such as increased public
disclosure of hedge fund activity, increased disclosure by public
companies of exposures to highly-leveraged hedge funds, enhanced private
sector risk-management practices, expanded risk-assessment authority for
regulators over unregulated broker dealers and futures commission
merchants, and increased off-shore hedge fund compliance with
international standards.[^102] Even the Chairman of the U.S. Federal
Reserve Board acknowledges the ongoing challenge.[^103]

Finally, although certain governmental bodies such as the U.S. General
Accounting Office and the Securities and Exchange Commission (SEC) have
recommended specific oversight practices and reporting requirements for
hedge funds,[^104] these practices and requirements do not focus on
systemic risk per se. The SEC, for example, is concerned about secret
agreements that give some, but not all, hedge-fund investors privileged
information about holdings or special redemption terms and about the
tendency of some hedge fund managers to overvalue fund assets to
maximize performance-based management fees or to hide losses.[^105]
These problems are real,[^106] but their significance pales in
comparison to the problem of systemic risk.[^107] Furthermore, the SEC
appears to lack the jurisdiction to attack even these peripheral
problems:

> \[M\]anaging systemic risk is a decision for the \[U.S.\] Treasury
> Department or the Federal Reserve, not the SEC. The SEC's charge is
> not to remedy concerns rooted in excessive leverage or complex
> derivatives transactions or otherwise to manage risk in financial
> markets. The fact that the SEC might worry about systemic risk does
> not give it jurisdiction over the matter . . . .[^108]

The primary lesson of these historical approaches is that attempts to
regulate systemic risk can be imperfect and messy. Other lessons are
quite secondary because the historical focus has been on bank systemic
risk whereas modern models of systemic risk should be additionally
focused on non-bank and market failures. To appreciate the difference,
consider the recent sub-prime mortgage crisis. The Federal Reserve
attempted to reduce the likelihood that this crisis might affect other
financial markets by cutting the discount rate, which is the interest
rate the Federal Reserve charges a bank to borrow funds when a bank is
temporarily short of funds.[^109] The European Central Bank and other
central banks similarly cut the interest rate they charge to borrowing
banks.[^110] These steps, however, impacted banks, not financial markets
directly.[^111] Furthermore, changes in monetary policy, such as cutting
interest rates, may not work quickly enough---or may even be too
weak---to quell panics, falling prices, and systemic collapse.[^112] The
models advanced in this article are intended to deter these failures by
augmenting, not replacing, traditional monetary policy. The article
therefore next considers potential future regulatory approaches to
complement monetary policy.[^113]

*Potential Future Approaches:*

To identify regulatory approaches, it is useful to think not only
conceptually but also in concrete terms. For the latter purpose, it
might be helpful to consider the following generic example, which is
consonant with the working definition of systemic risk suggested
here[^114] and consistent with supposition by the President's Working
Group on Financial Markets, Hedge Funds, Leverage, and the Lessons of
Long Term Capital Management[^115] as well as testimony before the U.S.
House of Representatives' Committee on Banking and Financial
Services[^116] of what a systemic market meltdown could look like. A
large hedge fund or private-equity company defaults. Its many
contractual counterparties rush to try to close out or otherwise protect
their positions on hundreds of billions of dollars in transactions. As a
result, collateral is liquidated and assets are sold in "fire-sales,"
causing prices to drop sharply.[^117] The price-drops in turn exacerbate
the rush to close out positions, which in turn causes prices to drop
further. The price-drops become so severe that one or more capital
markets stop functioning, at least temporarily. Investors lose
confidence and begin withdrawing their money from the remaining capital
markets, weakening those markets and---due to a perception, if not
reality, of heightened default risk---leading to a significant widening
of credit spreads and a resulting higher cost of capital. In a vicious
cycle, the increased cost of capital triggers defaults, and also causes
further liquidations of positions (to generate cash) and thus further
price-drops.[^118]

Based on the normative rationales for regulating systemic risk, the
lessons of historical regulation, and the foregoing example, this
article next examines a range of potential regulatory approaches.
Certain of these approaches are ex ante preventative, or prophylactic,
to reduce the risk of systemic collapse, others are ex post reactive to
mitigate the spread and consequences of systemic collapse.

[Averting Panics]{.underline}. The ideal regulatory approach is to try
to eliminate the risk of systemic collapse, *ab initio*. This
theoretically could be achieved by preventing financial panics, since
they are often the triggers that commence a chain of failures.
Economists sometimes refer to this approach as the "monetarist"
approach, identifying systemic risk with banking panics that produce
monetary contraction.[^119] This approach appears to be a key feature of
existing bank regulation, in which governmental deposit insurance is
aimed at preventing bank runs.[^120] Panics can trigger market failures
even outside the banking arena, however, such as when doubt arising over
a market's future liquidity triggers a stampede to sell first while the
market is still liquid, thereby inadvertently destroying the market's
liquidity[^121]; or, as in the generic example of a systemic market
meltdown,[^122] when contractual counterparties rush to try to close out
their positions, causing prices to drop so sharply that one or more
capital markets stop functioning (at least temporarily), which in turn
leads to a vicious cycle in which investors lose confidence.[^123]

Imposing regulation to help avert panics can facilitate the goal of
stability. In the context of the above generic example, regulation might
place conditions on closing capital markets and provide liquidity to
keep them open, thereby obviating the vicious cycle that would be
triggered if one or more such markets stopped functioning. Had this type
of regulation been in place, some believe it would have alleviated the
East Asian capital crisis of 1997-98.[^124] Incongruously, sometimes
stability can be achieved by closing down capital markets to halt
price-drops,[^125] though this can backfire by actually increasing
investor panic.[^126]

Any regulation aimed at preventing panics that trigger systemic risk,
however, could fail to anticipate all the causes of these panics. A
former Vice Chairman of the Board of Governors of the U.S. Federal
Reserve System believes, for example, that financial "panics can be set
off by any number of things."[^127] Furthermore, even when identified,
panics cannot always be easily averted. Consider, for example, price
shocks that cause panics.[^128] These shocks should not result from
known risks because rational investors will price in the cost of those
risks.[^129] But investors are not always rational. Earlier this decade,
"high-yield corporate bonds (formerly known as junk bonds) were able to
attract investors only by offering interest rates eight to 10 percentage
points higher than U.S. government bonds."[^130] By early 2007, however,
high-yield bonds could attract investors by offering interest rates
merely "little more than two percentage points" higher than government
bonds.[^131] Although the reason for this marked decline in the risk
premium is unclear,[^132] it may be attributable in part to the
availability heuristic[^133]: investors became complacent after
observing that "the bursting of the technology bubble of the 1990s
failed to produce a global disaster."[^134] It may also be attributable
to herd behavior, which economists call the "bandwagon effect,"[^135]
under which investors follow the trends in markets and potentially
overvalue or undervalue assets,[^136] thereby making irrational
investment decisions.[^137]

Furthermore, because the same trigger can foreshadow small consequences
some times and large consequences other times, regulation intended to
avert panics should attempt to take into account what it is beyond the
triggering event that sorts the magnitude of the consequences, and
should apply only to deter panics that trigger large consequences. It is
questionable, though, whether such a sorting mechanism is always
discernible ex ante.[^138] Without such a sorting mechanism, regulation
can impede market growth or undermine the market experimentation and
innovation on which growth depends. For example, an underlying cause of
the recent sub-prime mortgage-related crisis was that mortgage loans
turned out to be undercollateralized, due to the drop in home
prices.[^139] One could deter a future such crisis by regulating a
collateral-value restriction on mortgage loans[,]{.smallcaps} perhaps
akin to that imposed on so-called "margin" loans after the Great
Depression.[^140] Mortgage lenders would then have to discount home
values to anticipate the possibility of falling home prices. But that
would not only significantly impede the growth in home ownership but
also impose a high administrative cost on lenders as well as on
government employees monitoring the regulation.

[Disclosure]{.underline}. Another potential prophylactic approach is
disclosure. Disclosing risks traditionally has been viewed, at least
under U.S. securities laws, as the primary market-regulatory
mechanism.[^141] It works by reducing, if not eliminating, asymmetric
information among market players, making the risks transparent to
all.[^142] It therefore might seem that, in a world of perfect
disclosure, financial panics would be minimized because investors would
price in all risks.[^143] Indeed, the government report issued after
LTCM's near-failure recommended increased public disclosure by hedge
funds.[^144]

In the context of systemic risk, however, individual market participants
who fully understand that risk will be motivated to protect themselves
but not the system as a whole.[^145] Requiring non-public entities such
as hedge or private-equity funds to disclose their financial condition
or leverage would thus do relatively little to deter systemic risk,
since investors or counterparties of those entities are unlikely to care
about that disclosure to the extent it pertains to systemic risk.
Furthermore, those investors and counterparties already demand, and
usually receive, disclosure to the extent it helps them assess the
merits of their investments, qua investments.[^146]

Commentators also have argued that imposing additional disclosure
requirements may even be counterproductive, one contending that market
participants presently have an incentive to carefully investigate their
counterparties' creditworthiness but, if the market were regulated, less
experienced actors might engage in derivatives trading,[^147] another
arguing that increased disclosure would cause market participants to
change their behavior (e.g., traders would become more cautious,
demanding that prices move farther before making trades), thereby
ultimately reducing market liquidity.[^148]

The efficacy of disclosure is further limited by the increasing
complexity of transactions and markets.[^149] A contributing factor to
the recent sub-prime crisis, for example, is allegedly that "\[a\] lot
of institutional investors bought \[mortgage-backed\] securities
substantially based on their ratings \[without fully understanding what
they bought\], in part because the market has become so complex."[^150]
The complexity increases to the extent derivatives are involved; it has
been argued that investment strategies utilizing derivative instruments
are so complex that, even if disclosure is provided, sophisticated
investors (or regulators) might not be able to fully appreciate the risk
of any given strategy.[^151] This risk can be significant since
derivatives can allow leverage up to 1,000 times the amount of capital
put down.[^152]

This article does not purport to resolve the ongoing broader debate of
whether to regulate derivatives, absent effective disclosure.[^153] In
the context of systemic risk, however, the issue of derivatives
regulation is best viewed as bifurcated: regulation of derivatives used
for speculation, and regulation of derivatives used for hedging.
Derivatives used for speculation are thought to increase the potential
for systemic risk.[^154] Recently-enacted derivatives netting provisions
in the U.S. Bankruptcy Code,[^155] however, are aimed at mitigating this
risk.[^156] The extent to which these netting provisions will be
effective to reduce systemic risk is ultimately an empirical
question.[^157]

Derivatives used for hedging, in contrast, may actually reduce the
potential for systemic risk.[^158] Hedging is intended to protect
institutions from risk by using credit derivatives to diversify that
risk.[^159] The most widely used derivative instrument for this purpose
is the credit-default swap, under which one party agrees, in exchange
for receiving a fee paid by a second party, to assume the credit risk of
certain debt obligations of a specified borrower or other obligor. If a
"credit event" (for example, default or bankruptcy) occurs in respect of
that obligor, the first party will either (i) pay the second party an
amount calculated by reference to post-default value of the debt
obligations or (ii) buy the debt obligations (or other eligible debt
obligations of the obligor) for their full face value from the second
party.[^160] Hedging also is effected through risk securitization, in
which a company, bank, or other entity (a "hedged party") transfers the
credit risk of a portfolio of corporate loans, bonds or other debt
obligations to a special-purpose vehicle ("SPV"). The SPV raises funds
to support that assumption of risk by issuing securities to investors in
the capital markets. The SPV agrees to make certain predetermined
payments to the hedged party if the credit risk of the portfolio
increases (as determined by the default or bankruptcy of the borrowers
or other parties obligated to the hedged party respecting debt
obligations in the portfolio). Because any such payments would reduce
the SPV's assets from which investors receive repayment of their
securities, investors are exposed to the credit risk of the portfolio.
In return for assuming this risk, the hedged party pays the SPV fees
that are applied, along with the SPV's other assets, to repay the
investors at a rate-of-return appropriate to the risk.[^161]

These hedging strategies facilitate risk-spreading to parties better
able to bear the risks, including the "deep pockets" of the global
capital markets.[^162] This diversification of risk also reduces the
likelihood that a default will cause any given institution to fail, and
mitigates the impact of any such failure on other institutions---not
unlike the effect of limiting financial-exposure limits.[^163] On the
other hand, diversifying risk through hedging increases linkages among
market participants which, at least in part, could offset the risk
spreading and foster systemic risk: if an institution fails, it would
potentially impact many more other institutions. Furthermore, hedging
strategies sometimes fail,[^164] and diversification increases the
chance that some market participants may not fully understand the risks
they are taking on. The net effect of hedging strategies, however,
appears to be a positive reduction of risk.[^165]

Requiring additional disclosure would thus appear to do relatively
little to mitigate the potential for systemic risk, even to the extent
that potential results from the use of derivatives.

[Financial-Exposure Limits]{.underline}. The failure of one or more
large institutions (such as a large hedge fund, like LTCM) could create
defaults large enough to de-stabilize other highly-leveraged
investors,[^166] increasing the likelihood of a systemic market meltdown
(as illustrated by the generic example[^167]). This suggests another
possible approach to regulation: placing limits on inter-institution
financial exposure.[^168] Financial-exposure limits would facilitate
stability by reducing the losses of any given contractual counterparty,
and thus the likelihood that such losses would cause the counterparty to
fail. Such limits also might reduce the urgency, and hence the panic,
that contractual counterparties feel about closing out their
positions.[^169]

This approach is now applicable to banks through lending limits,
restricting the amount of bank exposure to any given customer's
risk.[^170] A way of thinking about these limits is that they assure
diversification of risk.[^171]

\[How well would this approach work,[^172] especially if extended beyond
banks? What are the costs of extending this approach beyond
banks/financial intermediaries? To what extent also might it retard
investment? Wouldn't diversification of risk be better if market driven,
since that eliminates the regulatory costs and rational market
participants naturally want to diversify their risk. The extension of
this approach beyond banks is currently being considered by some
financial leaders. The First Deputy Managing Director of the IMF, for
example, recently observed that many non-bank entities, including
conduits and structured investment vehicles (SIVs), have attempted to
limit financial exposure by undertaking maturity mismatches
traditionally associated with banks.[^173]\]

[Reducing Leverage]{.underline}. Reducing leverage is relevant to
systemic risk insofar as it reduces the risk that a financial entity
fails in the first place and also reduces the likelihood "that problems
at one financial institution could be transmitted to other
institutions."[^174] Absent leverage, institutions can absorb losses
linearly, dollar for dollar. Institutions may shrink, but they would not
default on debt. The less leverage, the less likely it is (other factors
being equal) that an institution would fail to pay its debts as they
mature.[^175]

High leverage, however, can cause institutions to absorb losses
"exponentially" in the sense that losses beyond a certain level
(depending on the institution's size and leverage) will precipitously
degrade an institution's ability to pay its debts. Default in paying
debts might well cause the institution's failure,[^176] as well as
trigger a potential chain of defaults as other institutions are not paid
amounts owed them (and, in turn, if highly leveraged, might then be
unable to pay amounts owed to yet other institutions).

Reducing leverage is therefore primarily prophylactic, reducing the risk
and mitigating the spread and consequences of systemic collapse.[^177]
Reducing leverage would also strongly facilitate the goal of stability.
It nonetheless could create significant costs. Some leverage is
good,[^178] though there is no optimal across-the-board amount of
leverage that is right for every company.[^179] Regulation that attempts
to track optimal leverage thus would be nuanced and highly complex, as
illustrated by the complexity of the Basel II capital adequacy
requirements. These requirements, designed to reduce leverage of banks,
mandate that banks hold minimum amounts of capital as a function of the
riskiness of their assets.[^180] It has been observed, however, that
"the advanced approaches of Basel II are 'too complex' for anyone to
understand, and the mathematical formulas in various drafts of the
framework can look like a foreign language to some readers."[^181]
Imposing unnunanced limitations on leverage, however, could impair a
firm's ability to operate efficiently and impede economic growth.[^182]

\[Consider[^183] possibly reducing leverage permitted by
derivatives.[^184] Discuss also the importance of "size matters," in
that small institutional failures are unlikely to result in failures to
pay amounts large enough to trigger other institutional defaults, so
perhaps limitations on leverage should be applied only to large firms.
Is there precedent for that, and might it violate equal protection under
the U.S. Constitution? Consider also the efficacy of this (reducing
leverage) approach in that structured finance can be used to mask
leverage.[^185]\]

[Ensuring Liquidity]{.underline}. This approach could facilitate
stability in two ways: by providing liquidity to prevent financial
entities from defaulting (or to prevent defaulting financial entities
from failing[^186]), and by providing liquidity to capital markets as
necessary to keep them functioning.[^187] This would strengthen these
two key links in the systemic meltdown chain,[^188] thereby strongly
facilitating the goal of stability. To the extent liquidity averts a
collapse, it functions prophylactically; but its primarily function is
reactive, to mitigate the spread and consequences of systemic collapse.

There are at least two possible regulatory ways to ensure liquidity:
creating a lender/market-maker of last resort (hereinafter, generically,
a "liquidity provider of last resort"), and imposing entity-level
liquidity requirements.[^189] In the former context, economists argue
that monetary contractions can occur when market crashes engender fears
that lenders will lack resources to extend loans.[^190] However, panic
will not usually become contagious (and thus systemic), they contend,
when a lender of last resort provides adequate liquidity.[^191] Thus, in
the case of the Great Depression, the negative effects would have been
considerably muted (they argue) through actions by the government
central bank to provide the needed liquidity to maintain stability
within the monetary supply.[^192]

Establishing a liquidity provider of last resort could be an expensive
proposition, potentially creating moral hazard and shifting cost to
taxpayers.[^193] It also could foster adverse selection. Nonetheless,
these costs may be controllable. The discussion below considers
controlling these costs first in the context of providing liquidity to
institutions by making loans, then in the context of providing liquidity
to markets by purchasing securities.

In the first context, the moral-hazard cost could be controlled, for
example, by following a policy of "constructive ambiguity" under which
the liquidity provider of last resort would have the right but not the
obligation to intervene, and the rules by which it decides which to do
would be uncertain to third parties.[^194] Additional ways to control
moral hazard might include setting qualification criteria for borrowing
and repayment incentives for borrowers,[^195] and requiring
coinsurance.[^196] And adverse selection costs could be controlled by
gathering information on and evaluating potential borrowers, limiting
the criteria by which loans are disbursed, and imposing covenants and
limitations on use of proceeds.[^197]

Any shifting of costs to taxpayers could also be controlled. Rather than
using taxation to establish the pool of funds from which the liquidity
provider of last resort could make advances, the pool could be funded,
for example, by charging "premiums" to market participants, not unlike
insurance. FDIC deposit insurance, for example, is financed in this
way.[^198] Even if the pool of funds is raised by taxes, the funds could
be invested to maintain their value until used, and loans could be
advanced at a market interest rate. The failure of the International
Monetary Fund ("IMF"), when acting as a lender of last resort to
sovereign states, to charge a market interest rate on its loans is
precisely what shifts costs to the taxpayers of IMF member-nations, who
fund the loans.[^199] That failure, however, is political and not
inherent in the concept of a lender of last resort.[^200]

Yet another way to avoid shifting costs to taxpayers is to privatize the
role of liquidity provider of last resort, or at least to reallocate the
source of liquidity-funding from taxpayers to private credit and other
capital markets.[^201] Privatization would not only minimize, if not
eliminate, taxpayer costs but also should minimize the moral hazard
\[and adverse selection\] costs. Number range CHAPTERThe discussion
below first examines how privatization could work in the context of
institutional systemic risk and then inquirers how market systemic risk
might affect the analysis.

Shifting the source of funding to capital markets would eliminate the
need for taxpayers to pay for the funding since the size of these
markets should be large enough to accommodate the legitimate financing
needs of troubled institutions.[^202] Such a shift also would
significantly reduce the problem of moral hazard because,
notwithstanding the size of these markets, an institution will have no
assurance that private credit will be available[^203]---and the risk of
potential default will make institutions more cautious. Furthermore, as
explained below,[^204] any conditions that a government-sponsored
liquidity provider of last resort imposes to minimize moral hazard could
be similarly imposed in a capital-market context.

As a practical matter, this approach could only work if capital-market
financiers obtained priority on their new loans to troubled
institutions. Without a priority, the information asymmetry between the
institution and potential financiers would likely be too large; after
all, the institution will be collapsing, and time will be of the essence
to avoid a systemic meltdown. A priority also will be needed because
new-money financiers would not want to be "taxed" by the claims of
existing creditors.[^205] The law could create priorities in many ways,
but the simplest is perhaps a statutorily-mandated priority not unlike
that set forth in bankruptcy law to attract new-money financing to help
reorganize troubled companies.[^206]

Giving priority to new-money financiers might create costs, most
significantly by effectively subordinating the institution's existing
unsecured creditors, thereby affecting ex-ante lending incentives and
potentially driving up the cost of credit. This cost, however, should be
minimal for two reasons. Even Number range CHAPTERa government-sponsored
liquidity provider of last resort is likely to demand priority,[^207] so
privatizing the funding would likely not create costs beyond that
created by any liquidity-provider-of-last-resort scheme. Furthermore,
granting priority to attract new-money credit "tends to create value for
unsecured creditors," even where those creditors' claims are
subordinated to the new money,[^208] since credit increases a borrower's
liquidity, thereby reducing its risk of failure and increasing the
expected value of unsecured claims.[^209]

Number range CHAPTERNew-money credit nonetheless could decrease value to
unsecured creditors if overinvestment occurs.[^210] Monitoring, though,
can limit the risk of overinvestment.[^211] Any law authorizing a
priority therefore should enable existing creditors to scrutinize and
object to excessive amounts of new-money priority financing and to
monitor its use as appropriate.

Under what conditions should the law authorize the priority (and
concomitant monitoring)? Although the law could attempt to specify those
conditions in advance, determining when a failing institution is likely,
absent liquidity, to trigger a systemic meltdown is probably a judgment
call that should be decided in light of all the circumstances. A neutral
government-sponsored agency could be assigned this decision-making role.
It might then be possible to combine the best of both worlds by enabling
the decision-making agency to disburse the capital-market funds through
non-recourse back-to-back lending, in which the agency borrows funds
from the capital markets on a non-recourse basis and re-lends those
funds to the institution, assigning the institution's priority loan to
the capital-market financiers as collateral.[^212]

The foregoing examination focused on a liquidity provider of last resort
providing liquidity to institutions by making loans. Consider next
providing liquidity to markets by purchasing securities.[^213] This is
different in at least three ways: (i) it is less obvious who would
request that liquidity be provided; (ii) it is less clear how priority
would be achieved on the purchased securities; and (iii) because markets
themselves would be at issue, it is dubious that capital markets would
be sufficiently robust, at the time, as a source of privatized
funding.[^214]

The first difference is not problematic since a government agency could
decide when liquidity should be provided. The second difference is
likewise surmountable. For example, the law could grant the liquidity
provider of last resort a priority in the purchased securities over
other securities of that type. Thus, a liquidity provider of last resort
purchasing bonds of XYZ Corporation would, if provided by law, obtain
priority of repayment over all other holders of XYZ bonds. Even without
a priority, however, the liquidity provider of last resort could
purchase market securities at a deep enough discount to ensure ultimate
repayment. Buying at a discount would also help to reduce moral hazard
without the need for a policy of constructive ambiguity to the extent
prices stabilize well below the levels paid by speculating investors.
The only question would be whether market prices stabilize at a
sufficient level to preserve a robust market if the necessary discount
is very large.

One might ask why, if a liquidity provider of last resort can invest at
a deep discount to stabilize markets and still make money, private
investors won't also do so, thereby eliminating the need for a liquidity
provider of last resort. The answer at least in part is that individuals
at investing firms will not want to jeopardize their reputations (and
jobs) by causing their firms to invest at a time when other investors
have abandoned the market. Empirical evidence confirms that individuals
engage in this type of herd behavior.[^215]

The third difference---that because markets themselves would be at
issue, it is dubious that capital markets would be sufficiently robust
as a source of funding---is less surmountable. There is, of course, a
middle ground: look first to capital markets as a source of last resort
funding, but maintain some backup source of taxpayer-funded liquidity in
case market funding is unavailable.[^216] In any event, the availability
of privatized funding is less important to the extent the liquidity
provider purchases securities with priority or at a deep discount,
thereby ensuring repayment in either case.

Nothing in this discussion of liquidity providers of last resort has
necessarily differentiated between domestic and international liquidity
demands. A threshold difference is identifying the entity that would act
as liquidity provider of last resort.[^217] This article later examines
who might act as an international liquidity-provider of last
resort.[^218]

The other possible regulatory means to ensure liquidity is to impose
entity-level liquidity requirements. Even in the banking context,
however, these types of requirements are expensive,[^219] and they would
be even harder to apply and manage in a broader context since the
entities would be less uniform. \[Consider also what entity-level
liquidity requirements would mean for non-bank entities.[^220]\] Nor
would entity-level liquidity requirements be applicable to ensuring
market liquidity.[^221]

[Ad Hoc Approaches]{.underline}. The extent to which ad hoc (that is,
purely reactive) regulatory responses to systemic risk facilitate
stability and efficiency is, of course, partly dependent on what those
responses turn out to be. Nonetheless, some general observations can be
made. For example, ad hoc approaches do not always work. Sometimes they
are too late and the harm has been done or no longer can be prevented,
and sometimes there is insufficient time to fashion and implement an
optimal solution. In these cases, ad hoc approaches do not strongly
facilitate the goal of stability, and therefore are second-best.

From an efficiency standpoint, ad hoc approaches can help to minimize
the difficulties in measuring, and balancing, costs and benefits. It may
be hard to quantify in advance, for example, the likelihood that the
failure of a given firm or other triggering event would cause a systemic
meltdown.[^222] Because ad hoc approaches are ex post in nature---by
definition, not initiated until the time of the potential failure---they
can make quantification easier.[^223] Furthermore, ad hoc approaches
reduce moral-hazard cost to the extent an institution cannot know in
advance whether, if it faces financial failure, it will be bailed out or
fail.[^224] For these reasons, central banks often pursue a policy of
"constructive ambiguity" in setting criteria whether to bail out failing
banks, effectively making the decision ex post on an ad hoc basis.[^225]

[Market Discipline]{.underline}. As the discussion of ad hoc approaches
has shown, regulatory approaches to systemic risk do not have to be
prescriptive ex ante. In a market context, moreover, they may not have
to be prescriptive at all. Some amount of bank "regulation," for
example, is believed to be imposed by the market itself.[^226]
Market-imposed regulation is efficient insofar as it minimizes
regulatory costs.[^227]

Although in theory perfect markets would never need external
regulation,[^228] actual markets, including financial markets, are not
perfect. Under a market-discipline approach, the regulator's job is to
ensure that market participants exercise the type of diligence that
enables the market to work efficiently.[^229] This is often achieved by
ensuring that market participants have access to adequate information
about risks, and by arranging incentives so those who influence an
institution's behavior will suffer if that behavior generates
losses.[^230] This is the type of approach taken by the United States
government under the second Bush administration to minimize hedge-fund
failure and the resulting possibility of systemic risk.[^231]

Market discipline is, superficially, a low-cost prophylactic regulatory
approach. For two reasons, however, a market-discipline approach only
weakly facilitates the goal of stability. Market discipline to avoid
systemic risk already has been shown to be inherently suspect because no
firm has sufficient incentive to limit its risk taking in order to
reduce the danger of systemic contagion for other firms.[^232] Perhaps
this helps explain why, even though the banking and securities-brokerage
industries have in large part been subject to a market-discipline
regulatory approach,[^233] significant potential for systemic risk from
an LTCM default was attributed to the overly "generous terms from the
banks and broker-dealers that provided credit \[to LTCM\] and served as
counterparties."[^234]

Furthermore, even outside of the systemic-risk context, regulators have
a mixed track record, absent prescriptive rules, of ensuring that
participants exercise market discipline.[^235] Until the recent
sub-prime mortgage debacle, industry observers were expressing concern
that banks were increasingly competing to make loans without financial
covenants, although it is questionable whether that constitutes "safe
and sound" banking practice[^236]---a standard of self-discipline that
regulators are supposed to ensure that banks follow.[^237] The marked
decline in the risk premium that has been charged by investors may well
represent yet another example of weak market discipline.[^238]

This mixed track record of ensuring that participants exercise market
discipline can be partly explained by behavioral psychology. Investors
cannot accurately price risks that rarely occur and are
unpredictable.[^239] In the context of political risk, for example,
investors "often alternate between assessments \[of that risk\] that, in
hindsight, were either much too high or much too low," creating a
"*pattern* . . . of alternating optimism and skittishness."[^240] This
pattern partly reflects "availability bias," or the tendency of a recent
crisis to be the most available concept in an investor's mind.[^241] In
part, also, it reflects the documented human tendency to underestimate
the likelihood of very rare but potentially devastating risks.[^242] A
similar alternating pattern would be expected in the systemic-risk
context, which (like political risk) is both rare and
unpredictable.[^243]

Occasional failures by regulators to maintain market discipline also may
reflect the almost endemic shortage of funding for regulatory monitoring
as well as potential political bias against interfering with
markets.[^244] According to the U.S. General Accounting Office (GAO),
for example, the SEC has had an increasingly inadequate labor force
since 1995.[^245]

Thus, although market discipline is attractive as a supplement to other
regulatory approaches, there is some doubt whether it should serve as
the exclusive, or even primary, regulatory mechanism.

C. [Assessing Regulatory
Approaches]{.underline}[]{#__RefHeading___Toc172539228 .anchor}

The discussion above has identified potential regulatory approaches. The
article now attempts to assess these approaches, first by examining
cost-benefit balancing as a means of assessment, then by considering
whether that balancing should be influenced by possible application of a
precautionary principle, and finally by assigning possible values to the
balancing.

*Cost-Benefit Balancing and the Precautionary Principle:*

Cost-benefit balancing, as has been discussed, is a means of measuring
the efficiency of regulation.[^246] It is also a well-recognized test
for regulatory political viability. For example, before any major rule
may take effect, U.S. regulatory agencies must submit a cost-benefit
analysis to Congress.[^247] To this end, regulatory agencies use a
variety of methodologies to evaluate regulations,[^248] including
applying different values when monetizing the costs and benefits of
regulations.[^249] Regulatory evaluations also can take into account
non-quantifiable benefits and costs that may have been key factors in an
agency's decision to promulgate a rule.[^250]

To the extent regulation deals with health and safety issues (as could
arise in the case of systemic risk[^251]), agencies go even further
beyond strictly econometric cost-benefit modeling. Perhaps the most
relevant example for systemic risk is regulation designed to address the
risk of catastrophic events or large, irreversible effects where the
actual level of risk is indeterminate.[^252] In these cases, regulators
often apply a precautionary principle, which allows regulation based on
a presumption that benefits will outweigh costs.[^253] In the
principle's most utilized form, regulators may decide to regulate an
activity notwithstanding lack of decisive evidence of the activity's
harm, such as controlling low-level exposure to carcinogens
notwithstanding lack of proof of a causal connection between such
exposure and adverse effects to human health.[^254] Regulation should
not be blindly precautionary[^255] but should be proportional to the
chosen level of protection based upon an examination of potential
benefits and costs, which include non-economic considerations including
public acceptability and the preeminence of health over economic
considerations.[^256]

*Assigning Possible Values to the Cost-Benefit Balancing:*

Applying these principles, the costs would be those of implementing the
regulatory approach to reduce systemic risk, and the benefits would be
measured by the *costs saved* by avoiding the risk. These saved costs
would likely be high because they include not only direct economic costs
but also indirect social costs.[^257] Because the benefits (i.e., saved
costs) would be realized only if systemic risk that otherwise would
occur is avoided, they should be discounted by the less-than-100%
probability that systemic risk will occur,[^258] taking into account the
also less-than-100% probability that regulation will avoid it.
Regulation would be efficient whenever the expected value of those costs
with regulation were less than that without regulation.[^259]

Formulaically, the expected value computations can be described as
follows:

> Expected Value (without regulation) = \[likelihood of systemic
> meltdown without regulation\]% Number range CHAPTER× \$\[cost of
> systemic meltdown\] + \[likelihood of avoiding systemic meltdown
> without regulation\]% Number range CHAPTER× \$\[cost of having avoided
> systemic meltdown\]
>
> Expected Value (with regulation) = \[likelihood of systemic meltdown
> with regulation\]% Number range CHAPTER× \$\[cost of systemic
> meltdown\] + \[likelihood of avoiding systemic meltdown with
> regulation\]% Number range CHAPTER× \$\[cost of having avoided
> systemic meltdown\] + \$\[cost of regulation\]

To portray these equations more elegantly, let these amounts be
represented by symbols, where

*EV~1~* is the Expected Value, without regulation

*EV~2~* is the Expected Value, with regulation

γ is the likelihood of systemic meltdown without regulation, expressed
as a percentage

*M* is the cost of systemic meltdown, expressed in dollars

> *A* is the cost of having avoided systemic meltdown, expressed in
> dollars
>
> λ is the likelihood of systemic meltdown with regulation, expressed as
> a percentage

*R* is the cost of regulation, expressed in dollars

Using these symbols,

*EV~1~* = γ Number range CHAPTER× *M* + (1- γ) Number range CHAPTER× A

*EV~2~* = λ Number range CHAPTER× *M* + (1- λ) Number range CHAPTER×
*A* + *R*

One can simplify these equations by recognizing that *A*, the cost
(aside from the cost of regulation, *R*) of having avoided systemic
meltdown, equals zero. Therefore,

*EV~1~* = γ Number range CHAPTER× *M*

*EV~2~* = λ Number range CHAPTER× *M* + *R*

Systemic risk thus should be regulated if *EV~2~* is less than
*EV~1\ ~*(that is, if λ Number range CHAPTER× *M* + *R* is less than γ
Number range CHAPTER× *M*).

The interesting question, therefore, is how to estimate the values to be
used in these equations. Before examining what these values might be for
the regulatory approaches identified, a generic balancing can provide a
useful perspective. For this purpose, initially estimate γ, the
likelihood of systemic meltdown without regulation, at the two-year "25%
probability" prediction discussed at the Sixth Annual Conference of the
International Insolvency Institute.[^260] Even with regulation, there
must be some chance of systemic risk occurring, so initially---without
yet examining any particular regulatory approach---the article will
estimate that risk, λ, at 10% in two years[^261] on the theory that even
the best regulatory approach cannot eliminate the chance of systemic
risk. Although the cost of a systemic meltdown, *M*, is extremely
difficult to pin down, analysts at J.P. Morgan have estimated that
LTCM's failure would have cost its larger bank-creditors \$500-700
million *each*, not to mention the costs to others.[^262] The article
therefore will initially assume that *M* is likely to be at least \$1
billion, and perhaps far greater.[^263] Finally, although the cost of
regulation, *R*, is dependent on the type of regulatory approach,
initially assume it will not exceed \$100 million biannually.[^264]

Applying these values, 10% Number range CHAPTER× \$1,000,000,000 +
\$100,000,000 = \$200,000,000, which is less than 25% Number range
CHAPTER× \$1,000,000,000 = \$250,000,000. If these values are realistic,
regulation appears to be justified.

A quantitative analysis is no better than its assumptions, of course,
and this article's assumptions rely on no hard empirical data.
Furthermore, a truly realistic balancing of costs and benefits could
depend on the particular mechanisms by which systemic failures can
arise.[^265] The foregoing results should therefore be interpreted
cautiously. All that can truly be said with confidence is that so long
as *M*, the cost of a systemic meltdown, is much greater than *R*, the
cost of regulation, then regulation should be justified.

This provides, however, a useful way of thinking about the balancing,
especially since *M* is likely to be much greater than *R*.[^266]
Moreover, because a systemic meltdown can be catastrophic though the
actual level of risk is indeterminate,[^267] a precautionary principle
might appropriately apply to the balancing, allowing regulation based on
a presumption that benefits will outweigh costs.

Critics of regulation, on the other hand, might argue that actual
regulatory costs are likely to be much higher than \$100 million
biannually because any regulation would slow down economic growth, which
itself would be a cost.[^268] Because the equations above do not
discount *R*, any such slowdown in economic growth would significantly
increase *EV~2~*, making it less likely that regulation would be
justified. Presumably, though, even if regulation could potentially slow
down economic growth---and recall that any regulation should be crafted
as not to have that effect[^269]---a slowdown would not be inevitable,
so the cost of any slowdown should be discounted.

Next consider how these equations might apply to the specific regulatory
approaches previously identified.[^270] Of these approaches, several do
not seem worthy of further consideration. Regulation aimed at averting
panics would likely fail to anticipate all the causes of these panics,
would not necessarily deter even identified panics, and could impede
market growth; mandating increased disclosure would do relatively little
to deter systemic risk and may even be counterproductive; and placing
limits on inter-institution financial exposure or micromanaging
institutions to diversify risk through hedging might retard investment,
whereas institutions are market-driven anyway to diversify risk.[^271]
That leaves four potentially viable approaches: market discipline, ad
hoc approaches, reducing leverage, and ensuring liquidity.

Because market discipline has minimal regulatory costs, it is
necessarily efficient under the equations.[^272] It is nonetheless
suspect as a regulatory approach for two reasons: firms lack sufficient
incentive to limit risk taking in order to reduce the danger of systemic
contagion for other firms, and regulators have a mixed track record of
ensuring that participants exercise market discipline, absent
prescriptive rules.[^273] Market discipline therefore should be used as
a supplement to other regulatory approaches.

Ad hoc approaches do not quite fit, at least ex ante, into the equations
because they are, by definition, crafted after a crisis occurs or is
imminent. At that time, however, they are likely to be efficient in that
it is then easier to measure and balance costs and benefits.[^274] Ad
hoc approaches also reduce the moral-hazard cost.[^275] Nonetheless,
these approaches are inherently second-best: after a crisis occurs or is
imminent, there may well be insufficient time to implement optimal
solutions, and the harm already may have been done or can no longer can
be prevented.[^276] Ad hoc approaches therefore should be considered to
the extent a systemic meltdown threatens notwithstanding other
protections.

The remaining two regulatory approaches, reducing leverage and ensuring
liquidity, are more appropriately suited for testing under the equations
as potential solutions to the problem of systemic risk. Reducing
leverage reduces the risk that a financial entity will fail in the first
place, and also reduces the likelihood of a chain of institutional
failures.[^277] The trick, however, will be trying to find a simple way
of determining the appropriate maximum amount of leverage for different
types of companies---in each case a maximum that neither impairs the
companies' ability to operate efficiently nor impedes economic growth.
To reduce monitoring and other regulatory costs, such a limitation on
leverage might be imposed only on companies exceeding a certain size.
Still, monitoring and enforcement could be at issue to the extent
structured finance is used to mask leverage---though at least in the
United States, that use is increasingly discouraged.[^278]

Ensuring liquidity would help to prevent financial entities from
defaulting, and also would help to prevent defaulting financial entities
from failing. Liquidity additionally could be provided to capital
markets as necessary to keep them functioning. Of the two suggested ways
to ensure liquidity,[^279] creating a liquidity provider of last resort
appears to be simpler and easier to implement. Although establishing a
liquidity provider of last resort could be expensive, especially to the
extent it creates moral hazard, this expense could be controlled by
following a policy of "constructive ambiguity" in deciding whether to
lend[^280] or, when providing liquidity to markets, by buying securities
at a discount.[^281] Other costs of a liquidity provider of last resort
would appear to be modest.[^282]

Subject to the caveats noted,[^283] how might these two approaches fare
under a cost-benefit analysis? Although the expected value without
regulation, *EV~1~*, would not change, the expected value with
regulation, *EV~2~*, *would* change because both λ, the likelihood of
systemic meltdown with regulation, and *R*, the cost of regulation, are
functions of the particular regulatory approach. Consider first the
reducing-leverage approach. This approach would probably strongly reduce
the risk of a systemic meltdown. Therefore assume that λ = 5% for this
approach. But because the approach would be very expensive, assume, for
illustrative purposes, that *R* = \$1 billion. Inserting these values
into the equations,

*EV~1~* = γ x *M*

= \$250,000,000

*EV~2~* = λ x *M* + *R*

= 5% x \$1,000,000,000 + \$1,000,000,000

= \$1,050,000,000

Therefore, under these values, this regulatory approach, reducing
leverage, would not appear to be justified.

As mentioned, however, the cost of a systemic meltdown, *M*, is likely
to be far in excess of \$1 billion.[^284] Consider how the answer might
change if *M* were varied. Assume, for example, first that *M* = \$2
billion and then that *M* = \$5 billion. If *M* = \$2 billion, *EV~2~*
still would remain greater than *EV~1~*,[^285] so reducing leverage
again would not be justified as a regulatory approach. And, even if *M*
= \$5 billion, the equations would only reach a parity.[^286] Reducing
leverage therefore would not appear to be justified as a regulatory
approach unless ways can be found to significantly reduce its costs.

Next consider the approach of ensuring liquidity. This approach would
probably moderately reduce the risk of a systemic meltdown. Therefore
assume that λ = 10% for this approach. Although this approach could be
very expensive insofar as it fosters moral hazard, the article will
assume that moral hazard is controlled through a policy of constructive
ambiguity.[^287] Therefore assume, for illustrative purposes, that *R* =
\$100 million.[^288] Inserting these values into the equations,

*EV~1~* = γ x *M*

= \$250,000,000

*EV~2~* = λ x *M* + *R*

= 0.10 x \$1,000,000,000 + \$100,000,000

= \$200,000,000

It therefore appears that ensuring liquidity may well be a viable
regulatory approach since *EV~2\ ~*is \$50,000,000 less than *EV~1~*.
And the attractiveness of this regulatory approach would be dramatically
enhanced if the variations of *M* discussed above were applicable. For
example, if *M* = \$2 billion, *EV~2\ ~*would be \$200,000,000 less than
*EV~1\ ~*.[^289] And, if *M* = \$5 billion, *EV~2\ ~*would be
\$650,000,000 less than *EV~1\ ~*.[^290] This result, that *EV~2\ ~*is
less than *EV~1~*, is largely supported even if γ, the likelihood of
systemic meltdown without regulation, is stressed downward.[^291]

Therefore, even without the support provided by the precautionary
principle, it appears that ensuring liquidity should be justified as a
regulatory approach to the extent---as this article argues should be
possible[^292]---moral hazard can be minimized.

D. [Recommendations]{.underline}[]{#__RefHeading___Toc172539229 .anchor}

A regulation establishing a liquidity provider of last resort, then, is
the approach to minimizing systemic risk that would have the best chance
of success under any number of circumstances. The liquidity provider of
last resort would provide liquidity to help prevent critical financial
intermediaries from defaulting and to help prevent defaulting critical
financial intermediaries from failing. It also would provide liquidity
to capital markets as necessary to keep them functioning.[^293] In the
former case, the liquidity provider of last resort could minimize moral
hazard by adopting a policy of constructive ambiguity, refusing to
commit itself unequivocally to bailing out defaulting
intermediaries.[^294] In the latter case, the liquidity provider of last
resort could minimize moral hazard simply by buying securities at a
discount so that market prices stabilize at a level well below the
levels paid by speculating investors.[^295]

It is important that the liquidity provider of last resort be "in place"
because market collapses can occur rapidly and without warning.[^296]

The liquidity provider of last resort should not, or should only
minimally, shift costs to taxpayers. This can be accomplished, for
example, by charging premiums to market participants or by privatizing
the liquidity-provider-of-last-resort function or, where that function
is taxpayer-financed, by investing any pre-funded money to maintain its
value until used.[^297] Loans should be advanced at market interest
rates, and securities should be purchased at discounts. In either case,
the liquidity provider is more likely to recover its investment if it
receives priority of repayment on such loan advances and purchased
securities.

The foregoing should be supplemented by a market-discipline approach,
under which regulators would attempt to ensure that market participants
exercise the type of diligence that enables the market to work
efficiently.[^298]

To the extent these approaches fail to deter a systemic meltdown,
government should seek to prevent the meltdown or mitigate its impact by
implementing whatever ad hoc approaches appear, at the time, to be
appropriate.

Although some of these recommended approaches are prophylactic, aimed at
anticipating and preventing systemic collapses, and some are reactive,
focused on mitigating the spread and consequences of such collapses, the
reactive elements dominate.[^299] In part this reflects the aforesaid
tragedy of the commons, making traditional prophylactic protections,
including disclosure and other market-discipline measures, insufficient
to internalize costs. In part, also, it may reflect that cost-effective
prophylactic measures are simply difficult to craft. There are many ways
that systemic crises can occur, and trying to regulate all would dampen
the economy. For example, one could deter another sub-prime mortgage
crisis by regulating a collateral-value restriction on mortgage loans,
but that would impede home ownership and impose other costs.[^300] Even
without regulation, however, such a crisis might not be repeated,
whereas other, unforeseen crises may arise.

The foregoing analysis has examined systemic risk without necessarily
identifying or distinguishing the country or countries in which such
risk arises. Because financial markets and institutions increasingly
cross sovereign borders, a systemic collapse in one country inevitably
will affect markets and institutions in other countries.[^301] These
cross-border effects need to be addressed through international
regulation.

IV\. REGULATION IN AN INTERNATIONAL
CONTEXT[]{#__RefHeading___Toc172539230 .anchor}

International regulation of financial systems has been subject to a
roller coaster of a ride. In the latter years of World War II, the
Bretton Woods system was established to rebuild the international
financial framework and set transnational rules for monetary
policy.[^302] Central to this system was the fixing of exchange rates of
all major currencies to the U.S. dollar, with the value of the dollar
linked to gold at a guaranteed price of thirty-five dollars per
ounce.[^303] As a result, exchange rates were remarkably stable for the
next twenty-five years.[^304] By the 1960s, however, in the face of
rapidly expanding world trade, it became increasingly clear that the
gold supply was incapable of supporting the strong demand for global
liquidity.[^305] Faced with persistent payment deficits, the U.S. turned
in part to its gold reserves and even more substantially to U.S. dollars
to finance its debts, making the volume of dollars held by foreigners
soar and the U.S. gold reserves dwindle.[^306] In 1971, President
Richard Nixon instructed the U.S. Treasury Secretary to suspend all
sales and purchases of gold, marking the beginning of the end of the
Bretton Woods system and of fixed exchange rates.[^307]

The resulting deregulation and liberalization of financial markets
brought a substantial increase in cross-border capital flows and trade
in financial services.[^308] Initially acclaimed,[^309] deregulation is
now seen as a double-edged sword because unregulated financial
institutions and markets have become increasingly interdependent.[^310]
That, in turn, has increased the global market's exposure to systemic
risk.[^311] Can international regulation mitigate this risk?

Because this article's analysis of limiting systemic risk is not
necessarily tied to the United States or to a domestic financial system,
the article's recommendations---to establish a liquidity provider of
last resort, supplemented by a market-discipline approach and, as
needed, by ad hoc remedies---should theoretically have equal application
to limiting cross-border systemic risk. In an international context,
however, two issues emerge: is a single regulatory approach feasible,
and, if it is, who should act as the international liquidity-provider of
last resort (ILOLR)?

Whether or not feasible, a single regulatory approach certainly appears
desirable, being easier to adopt and administer in a global economy than
country-specific regulation and also lessening the potential for a
regulatory race to the bottom.[^312] Nonetheless, given the diversity of
approaches to financial regulation and supervision among various nations
of the world, some commentators believe that any single regulatory model
would be impractical.[^313] The optimal regulatory model, they argue,
must be customized for each country in accord with the structure and
size of the country's financial system, its specific regulatory and
supervisory objectives, and its unique historical evolution and
political traditions.[^314] At the very least, some of these observers
contend, the Anglo-American concept of fiduciary duty, which supports a
broad range of institutions and regulatory structures, is impossible to
replicate in the traditionally less stringently regulated Roman law
systems throughout Europe, Africa, Latin America, and many parts of
Asia.[^315]

These differences do not, however, appear to undermine the concept of a
single regulatory approach to systemic risk. Political scientists and
economists have observed that international cooperation is the natural
and most effective response of states that share an interest in averting
a common crisis that affects them individually---despite the many
historical, cultural, and legal differences that distinguish
nations.[^316] An otherwise effective regulatory approach to systemic
risk therefore ought to have the potential for international
applicability.[^317] Basel II indeed illustrates that a single
regulatory scheme for financial risk can be applied, at least in the
banking context, across diverse national financial systems.[^318]
Approximately 100 countries have signaled they will implement Basel II
by 2010.[^319]

A single regulatory approach thus appears feasible for mitigating
systemic risk. Who should act, however, as the ILOLR?[^320] There are at
least two obvious choices. One is the IMF, which sometimes already takes
on this role, albeit with controversy, in extending liquidity to
troubled sovereign states.[^321] Another choice would be one or more
national central banks, such as the U.S. Federal Reserve Bank or the
European Central Bank. Compare, for example, how the IMF and the Federal
Reserve might function in an ILOLR capacity.

At least one commentator argues that the Federal Reserve would be a
better ILOLR than the IMF. (Although the European Central Bank was not
in contention when the following comparison was made, the European
Central Bank is closely analogous to the Federal Reserve for purposes of
such comparison.) An ILOLR should ideally be able to advance funds in a
widely-used international currency, and the Federal Reserve is a source
of U.S. dollars.[^322] The IMF, in contrast, has no power to create
currency. The Federal Reserve also may have an advantage in that it is,
arguably, less bureaucratic than the IMF and thus capable of making
quicker decisions.[^323] Thus, the Federal Reserve (and, by analogy, the
European Central Bank) appears to have a better institutional capacity
than the IMF to act as an ILOLR.

On the other hand, any national central bank (including the Federal
Reserve or European Central Bank) acting as an ILOLR would face possible
conflicts of interest between its national and international
responsibilities. The IMF, in contrast, is a truly international
organization. Furthermore, through its access to member-state capital,
the IMF can theoretically spread the burden of responding to
international systemic risk.[^324] The IMF cannot, however, create
currency. It would not need that power if it has access to a potentially
unlimited amounts of currency,[^325] but such access would require
reform of the IMF's relationship with its member-states.[^326]

There therefore is no clear choice who should act, as among existing
institutions, as the ILOLR.

V. CONCLUSIONS[]{#__RefHeading___Toc172539231 .anchor}

This article is the first major work of legal scholarship on systemic
risk. It begins by carefully examining what systemic risk really means,
cutting through the confusion and ambiguity to establish basic
parameters. Economists and other scholars historically have tended to
think of systemic risk in terms of financial institutions such as banks,
and only infrequently in terms of financial markets. However with the
growth of disintermediation, in which companies can access capital
market funding without going through banks or other
intermediary-institutions, greater focus should be devoted to financial
markets and the relationship between markets and institutions.

This same focus reveals that the monetary-policy actions taken by the
Federal Reserve in the recent sub-prime mortgage crisis, although
helpful, would have been insufficient to stop a full-fledged systemic
collapse. This is because monetary-policy primarily impacts banks, not
financial markets, and it is markets, not banks, that are increasingly
at risk. This is not to say that monetary policy should be discarded,
merely that it must be augmented by measures that more directly address
systemic risk in markets.

This article attempts to identify and assess these measures. A threshold
question is whether regulatory measures are appropriate. The article
argues they are because, like a tragedy of the commons, market
participants have insufficient incentives, absent regulation, to limit
risk taking in order to reduce the systemic danger to others.

The article demonstrates the optimality of a multi-tiered regulatory
approach. A liquidity provider of last resort should be created to
provide liquidity, as appropriate to prevent systemic collapse, to
failing financial institutions and markets. Liquidity ensures maximum
flexibility because "\[i\]t could solve any problem, irrespective of its
cause. Trying to address . . . the cause \[\] is almost like fighting
the last war because the next problem will be different."[^327]

To minimize moral hazard, the liquidity provider of last resort could
lend under a policy of constructive ambiguity and invest in market
securities at a deep discount. If the liquidity provider is
governmental, it could minimize taxpayer costs by either charging
premiums to market participants or investing funds to maintain their
value until used and then charging market-rate interest on loans (or
taking market discounts on purchases). The
liquidity-provider-of-last-resort function also could be privatized. In
either case, the liquidity provider is more likely to recover full value
if it receives a repayment priority on its loans and investments.

The liquidity-provider-of-last-resort function should be supplemented by
market discipline, in which regulators attempt to ensure that market
participants exercise the type of diligence that enables the market to
work efficiently. To the extent these approaches fail to deter a
systemic meltdown, government should seek to prevent the meltdown or
mitigate its impact by implementing whatever ad hoc approaches appear,
at the time, to be appropriate.

Finance and markets being globally interconnected, systemic collapse in
one country inevitably will affect markets and institutions in other
countries. The article therefore also examines the feasibility of
internationally regulating systemic risk, the extent to which regulatory
solutions are universal or should be different for different countries,
and the potential for a regulatory race to the bottom if regulation is
done only on a national level.

Whether regulation is national or international, the choice of specific
regulatory approaches, including a realistic assessment of their costs
and benefits, ultimately may depend on the particular mechanisms by
which systemic failures can arise.[^328] To that extent, regulation is a
moving target since new financial instruments and markets continue to be
developed.[^329] For this reason, the article is necessarily only a
first step in conceptualizing potential solutions---intended to start,
but not end, the legal debate over systemic risk.

[^1]: Copyright  2007 by Steven L. Schwarcz. The author testified
    before the U.S. House of Representatives Committee on Financial
    Services on October 2, 2007 regarding this article's research and
    recommendations.

[^2]: Stanley A. Star Professor of Law & Business, Duke University
    School of Law; Founding/Co-Academic Director, Duke Global Capital
    Markets Center. E-mail: <schwarcz@law.duke.edu>. The author thanks,
    for their invaluable comments, Douglas Arner, Lissa Broome, Corinna
    Lain, Geoffrey P. Miller, Thomas Russo, Daniel Schwarcz, Joseph
    Sommer, Jonathan Wiener, . . . , participants in faculty workshops
    at Duke Law School, The University of Richmond School of Law, . . .
    . , participants in the seminar in Private Equity & Hedge Fund Law
    at Duke Law School, and members of the Advisory Board of the Global
    Capital Markets Center. He additionally thanks Jonas V. Anderson,
    Nicholas D. George, Christopher E. Stiner, William Stewart, and
    Michael Sullivan for excellent research assistance, funding for
    which was provided in part by the Global Capital Markets Center, and
    Joan Magat for helpful editorial assistance.

[^3]: *See, e.g., Systemic Risk: Examining Regulators' Ability to
    Respond to Threats to the Financial System: Hearing Before the H.
    Committee on Financial Services*, 110^th^ Cong. (Oct. 2, 2007),
    available at
    http://www.house.gov/apps/list/hearing/financialsvcs_dem/ht1002072.shtml
    (hereinafter *Systemic Risk Hearing*).

[^4]: Randal Smith, Carrick Mollenkamp, Joellen Perry, & Greg Ip,
    *Loosening Up: How a Panicky Day Led the Fed to Act*, [Wall
    St]{.smallcaps}. J., Aug. 20, 2007, at A1. *See also* Robert A.
    Eisenbeis et al., "An Analysis of Systemic Risks Posed by Fannie Mae
    and Freddie Mac and an Evaluation of the Policy Options for Reducing
    Those Risks" 13 (Apr. 2006) (Federal Reserve of Atlanta working
    paper 2006-2) (warning that the failure of Fannie Mae or Freddie Mac
    could create credit restraints having negative real effects on
    liquidity and the issuance of mortgages). \[Get more current
    cites.\] Concern about systemic risk also has arisen in the
    insurance industry. The fear is that the collapse of an insurer or
    reinsurer could cause a chain reaction of collapses, depriving
    business of the insurance needed to operate. Chris Mundy, *The
    Nature of Systemic Risk: Trying to Achieve a Definition*, 12
    [Balance Sheet]{.smallcaps}, No. 5, at 30 (2004) (discussing that
    post-911, the aviation insurance industry temporarily had to reduce
    insurance coverage below the level at which airlines
    could---according to their loan covenants and regulatory
    restrictions---continue to operate; and that governments had to
    intervene to provide coverage).

[^5]: A hedge fund is, essentially, a private and unregistered
    investment vehicle. Registration Under the Advisers Act of Certain
    Hedge Fund Advisers, 69 Fed. Reg. 72,054, 72,055 (Dec. 10, 2004) (to
    be codified at 17 C.F.R. pt. 275, 279). In today's market
    environment, hedge funds commonly take investor "equity" money and
    also borrow money to make market bets, including leveraged bets
    (through derivatives) on market movements. From the standpoint of
    investors, the goal of hedge funds is to achieve high rates of
    return. From the standpoint of hedge fund managers, the goal is to
    earn substantial management fees. Hedge funds are estimated to have
    assets exceeding a trillion dollars. Troy A. Paredes, *On the
    Decision to Regulate Hedge Funds: The SEC's Regulatory Philosophy,
    Style, and Mission*, 2006 [U. Ill. L. Rev.]{.smallcaps} 975, 981--82
    (2006).

[^6]: *See infra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text.

[^7]: *See, e.g.,* [Report of the President's Working Group on Financial
    Markets, Hedge Funds, Leverage, and the Lessons of Long Term Capital
    Management 31-32 (]{.smallcaps}April 1999) (hereinafter,
    "[President's Working Group")]{.smallcaps} (recommending measures to
    restrain excessive leverage of hedge funds); [U.S. General
    Accounting Office (GAO)]{.smallcaps}, [Long Term Capital Management:
    Regulators Need to Focus Greater Attention on Systemic Risk 14-15
    (O]{.smallcaps}ct. 1998) (discussing the concern of regulators for
    the potential risks posed by hedge funds during period of declining
    credit standards); [Staff Report to the United States Securities and
    Exchange Commission, Implication to the Growth of Hedge Funds,
    89]{.smallcaps} (Sept. 2003) (recommending that the SEC amend Rule
    203(b)(3)-1 to redefine "client" such that most hedge funds would
    require registration with the SEC); Anthony W. Ryan, Assistant
    Secretary for Financial Markets, U.S. Department of the Treasury,
    Remarks before the Managed Funds Association Conference (June 11,
    2007) (transcript on file with author). *See also* Ben S. Bernanke,
    Chairman, Board of Governors, U.S. Federal Reserve System, Remarks
    at the Federal Reserve Bank of Atlanta's 2006 Financial Markets
    Conference, Sea Island, Georgia (May 16, 2006) (transcript available
    at
    <http://www.federalreserve.gov/Boarddocs/speeches/2006/200605162/default.htm>)
    (offering thoughts on the systemic risk implications of the rapid
    growth of the hedge fund industry and on ways that policymakers
    might respond to those risks); Comments by Richard Blumenthal,
    Attorney General of Connecticut, The Diane Rehm Show, National
    Public Radio, May 9, 2007 (arguing that hedge funds should be
    regulated to avoid systemic risk).

[^8]: *See* John Gieve (Deputy Governor, Bank of England), Speech at the
    Centre for the Study of Financial Innovation Roundtable: Financial
    System Risks in the UK---Issues and Challenges (July 25, 2006)
    (observing the shift away from bank dominated finance); Andre Icard
    (Deputy Manager for the Bank for Int'l Settlements \[BIS\]), *Risk
    Measurement and Systemic Risk*, Speech at the Fourth Joint Central
    Bank Research Conference on Risk Management and Systemic Risk (Nov.
    8, 2005), *available at* www.bis.org/speeches/sp051108.htm
    (discussing the "evolution of systemic risk" to include
    interdependencies among banks, financial markets, and market
    infrastructure); Yutaka Yamaguchi, *Triangular View of Systemic Risk
    and Central Bank Responsibility*, Speech for the Third Conference on
    Risk Measurement and Systemic Risk (Bank for Int'l Settlements)
    (2002), *available at* http://www.bis.org/cgfs/conf/mar02h.pdf.
    (warning that in order to understand systemic risk, one must
    investigate the nexus among the banking system, financial markets,
    and the real economy). *Cf.* Gabriel Kolko, *Weapons of Mass
    Financial Destruction*, LE MONDE DIPLOMATIQUE, Oct. 2006, at 1,2
    (Eng.), available at <http://mondediplo.com/2006/10/02finance>
    (observing that the IMF is concerned that bank deregulation has
    allowed financial systems to become more vulnerable to systemic risk
    and to a growing number of financial crises).

[^9]: [Oxford English Dictionary]{.smallcaps}, general definition (2)
    (2d ed. 1989).

[^10]: George G. Kaufman, Bank Failures, Systemic Risk, and Bank
    Regulation, [The Cato Journal,]{.smallcaps} Vol. 16 No.
    1[,]{.smallcaps} at 4, *available at*
    http//:www.cato.org/pubs/journal/cj16n1-2.html. Kaufman points out
    that this definition is consistent with that of other leaders in the
    banking and regulatory field. For example, the Bank for
    International Settlements (BIS) has defined systemic risk as the
    "risk that the failure of a participant to meet its contractual
    obligations may in turn cause other participants to default." *Id.*
    The head of the San Francisco Federal Reserve Bank has defined it as
    the "risk that one bank's default may cause a chain reaction of . .
    . failures and even threaten the solvency of institutions." *Id.*

[^11]: Paul Kupiec & David Nickerson, *Assessing Systemic Risk Exposure
    from Banks and GSEs Under Alternative Approaches to Capital
    Regulation*, 48 J. [Real Estate Fin. & Econ]{.smallcaps}. 123, 123
    (2004) (observing further that a "key feature in the propagation of
    such a systemic shock is acute uncertainty regarding an
    institution's ability to satisfy its immediate payment obligations
    and a simultaneous inability of counterparties to hedge such risk").

[^12]: This is the definition favored by the Commodity Futures Trading
    Commission. *See*
    [http://www.cftc.gov/opa/glossary/opaglossary_s.htm]{.underline}.
    *Cf.* Nicholas Chan et al., *Systemic Risk and Hedge Funds*, EFA
    Moscow Meeting Paper, at 1 (Feb. 22, 2005), available at
    http:/ssrn.com/abstact=671443 (defining systemic risk as "the
    possibility of a series of correlated defaults among financial
    institutions---typically banks---that occurs over a short period of
    time, often caused by a single major event").

[^13]: The third definition focuses solely on repercussions to market
    participants.

[^14]: Kaufman, *supra* note Error: Reference source not found, at 4 n.
    5 (quoting Alan Greenspan, Remarks at a Conference on Risk
    Measurement and Systemic Risk, Board of Governors of the Federal
    Reserve System, Washington, D.C. (1995)).

[^15]: *Id.*

[^16]: The classic example of a tragedy of the commons is an overgrazed
    pasture resulting from common ownership so that no individual owner
    has the right to exclude use by other owners. *See* Garret Hardin,
    *The Tragedy of the Commons*, 162 [Science]{.smallcaps} 1243,
    [1244]{.smallcaps} (1968). The original concept of a tragedy of the
    commons can be traced back to Aristotle. [Aristotle,
    Politics]{.smallcaps} (Courier Dover, trans. by Benjamin Jowett) 57
    (2000) (observing that "that which is common to the greatest number
    has the least care bestowed upon it. Every one thinks chiefly of his
    own, hardly at all of the common interest.").

[^17]: Tragedies of the commons sometimes can be addressed by regulators
    informally pressuring parties to work collectively. *See* Armin
    Falk, Ernst Fehr, & Urs Fischbacher *Appropriating the Commons: A
    Theoretical Explanation*, *in* [The Drama of the
    Commons]{.smallcaps} 158 (Elinor Ostrom et al. eds., 2002). This
    approach is discussed *infra* notes Error: Reference source not
    found-Error: Reference source not found and accompanying text
    (discussing market discipline as an approach, and showing why it is
    insufficient).

[^18]: *See infra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text.

[^19]: Statement by William J. McDonough, President of the Federal
    Reserve Bank of New York, before the Committee on Banking and
    Financial Services, U.S. House of Representatives, Oct. 1, 1998
    (stating that the most important direct consequence of systemic risk
    brought on by a failure of Long Term Capital Management would have
    been "increases in the cost of capital to American businesses").
    *See also* E[.P. Davis, Debt, Financial Fragility, and Systemic Risk
    117 (1992) (]{.smallcaps}describing the ultimately worst
    consequences of systemic risk as "disrupt\[ing\] the payments
    mechanism and the capacity of the financial system to allocate
    capital").

[^20]: Mundy, *supra* note Error: Reference source not found, at 29.

[^21]: [R. W. Hafer, The Federal Reserve System: An
    Encyclopedia]{.smallcaps} 25, 145 (2005) (observing that a bank's
    cash reserves are often less than 5% of its deposits).

[^22]: Kaufman, *supra* note Error: Reference source not found, at 4.
    *See also* Juergen Eichberger & Martin Summer, *Bank Capital,
    Liquidity and Systemic Risk*, Working Paper series of the
    Oesterreichische Nationalbank (Working Paper 87), [3]{.smallcaps}
    (2004), *available at*
    http://www.oenb.at/de/img/wp87_1\_\_tcm14-9846.pdf.

[^23]: Kaufman, *supra* note Error: Reference source not found, at 4.
    *See also* Icard, *supra* note Error: Reference source not found
    (discussing how disturbances could arise and spread within the
    banking sector).

[^24]: Michael D. Bordo, Bruce Misrach, & Anna Schwartz, NBER Working
    Paper Series (No. 5371), *Real Versus Pseudo-International Systemic
    Risk: Some Lessons From History* [3, 21 (]{.smallcaps}1995).

[^25]: *Id.* at 21. To some extent this was in order to obtain funds to
    satisfy margin calls, and to some extent this was simply in panic.

[^26]: *Id.*

[^27]: Gary Richardson, *Bank Distress During the Great Contraction,
    1929 to 1933, New Data from the Archives of the Board of Governors*
    24 (Nat'l Bureau of Econ. Research, Working Paper No. 12590, 2006)
    (concluding that between 20% and 50% of bank failures were due to
    contagion/illiquidity chains). *But cf.* Charles W. Calomiris &
    Joseph R. Mason, *Causes of U.S. Bank Distress During the
    Depression* 32--33 (Nat'l Bureau of Econ. Research, Working Paper
    No. 7919, 2000) (arguing that most banks failed during the Great
    Depression for endogenous reasons and not because of financial
    intertwining).

[^28]: Bordo, Misrach, & Schwartz, *supra* note Error: Reference source
    not found, at 21.

[^29]: [Frederic S. Mishkin, The Economics of Money, Banking, and
    Financial Markets]{.smallcaps} 261 (7th ed. update 2006).

[^30]: Steven L. Schwarcz, *Enron and the Use and Abuse of Special
    Purpose Entities in Corporate Structures,* 70 [U. Cin. L.
    Rev]{.smallcaps}. 1309, 1315 (2002). Capital markets are now the
    nation's and the world's most important sources of investment
    financing. *See, e.g.,* McKinsey Global Institute, Mapping the
    Global Capital Markets Third Annual Report (Jan. 2007), reporting
    that as of the end of 2005, the value of total global financial
    assets, including equities, government and corporate debt
    securities, and bank deposits, was \$140 trillion, available at
    <http://www.mckinsey.com/mgi/publications/third_annual_report/index.asp>.

[^31]: *Cf.* Bordo et al., *supra* note Error: Reference source not
    found (observing that "recent literature is less concerned than it
    was in earlier times with contagious banking panics as the key
    source of systemic risk").

[^32]: [Wesley B. Truitt, The Corporation]{.smallcaps} 107--09 (2006).
    Firms often use capital markets to turn illiquid assets into cash.
    For instance, through securitization, banks can turn long-term
    mortgages into easily tradable securities. [Meir Kohn, Financial
    Institutions and Markets]{.smallcaps} 381 (2d ed. 2004). Firms can
    also borrow more cheaply through bonds and commercial paper than
    they can from banks. *See Id.* at 145.

[^33]: Yamaguchi, *supra* note Error: Reference source not found.
    Yamaguchi, the former Deputy Governor of the Bank of Japan, warns
    that financial markets now play a role as sources of systemic
    disturbances. *Id.* at 1.

[^34]: Icard, *supra* note Error: Reference source not found, at 5. Bank
    deposits are merely a form of lending, from depositors to the bank.
    *See* Citizens Bank v. Strumpf, 116 S. Ct. 286, 290 (1996).

[^35]: *Cf.* [Richard A. Posner, Economic Analysis of Law]{.smallcaps}
    446 (6^th^ ed. 2003).

[^36]: *Cf.* [Posner,]{.smallcaps} *supra* note Error: Reference source
    not found, at 446 (arguing that risk that is positively correlated
    with the market itself cannot be diversified away). Judge Posner
    implicitly assumes, of course, that the market risk at issue cannot
    be diversified away by investing in unlinked diverse markets.

[^37]: [Roger Lowenstein, When Genius Failed: The Rise and Fall of
    Long-Term Capital Management]{.smallcaps} 86, 144--46, 164, 169--70
    (2000).

[^38]: Statement by McDonough, *supra* note Error: Reference source not
    found (describing ways that the problems of LTCM could have caused
    more widespread financial troubles).

[^39]: *Id.*

[^40]: *See supra* note Error: Reference source not found (the President
    of the Federal Reserve Bank of New York concluding that the most
    important consequence of systemic risk brought on by a failure of
    LTCM would have been increasing the cost of capital).

[^41]: Under the terms of this workout, existing lenders converted some
    of their debt to 90% of equity in LTCM and invested \$3.65 billion
    of additional capital. [Lowenstein,]{.smallcaps} *supra* note Error:
    Reference source not found, at 209--10.

[^42]: *See supra* note Error: Reference source not found and
    accompanying text.

[^43]: A derivative is a contract under which the parties agree to
    exchange payments calculated by reference to the price of a
    commodity or financial instrument, a rate, index, or some other
    economic measurement. *See* [Christian A. Johnson, OTC Derivatives
    Documentation]{.smallcaps} 1 (2005).

[^44]: *Cf.* [President's Working Group,]{.smallcaps} *supra* note
    Error: Reference source not found, at [23]{.smallcaps} (observing
    that the "indirect impact" on markets of the failure of individual
    market participants is potentially "more serious" than such failure
    itself: "\[v\]olatility and sharp declines in asset prices \[that\]
    can heighten uncertainty about credit risk and disrupt the
    intermediation of credit," which in turn "could cause a contraction
    of credit and liquidity, and ultimately\[\] heighten the risk of a
    contraction in real economic activity"). *See also supra* note
    Error: Reference source not found and accompanying text.

[^45]: Although the above paragraph focuses on systemic risk resulting
    from hedge-fund failure, hedge funds might indirectly contribute to
    *bank* systemic risk insofar as hedge-fund lack of regulation
    enables them to make relatively risky investments, including risky
    loans. This may be forcing banks, in order to compete, to make loans
    without financial covenants. Interview with Douglas Rosefsky,
    Managing Director, Alvarez & Marsal (Durham, Mar. 21, 2007). This
    dilemma, however, does not arise out of the nature of hedge funds
    qua hedge funds but, rather, out of their unregulated nature,
    enabling them to make risky investments if they choose to do so.
    Moreover, it is questionable whether making loans without financial
    covenants (sometimes called "covenant-lite loans") even constitutes
    "safe and sound" banking practice. *Cf.* Grover R. Castle, *Term
    Lending---A Guide to Negotiating Term Loan Covenants and Other
    Financial Restrictions*, [J. Com. Bank Lending]{.smallcaps} 30-33
    (Nov. 1980) (tables showing that most bank loans contain financial
    covenants); [Joël Bessis, Risk Management in Banking
    514]{.smallcaps} (2d ed. 2002) ("Covenants become essential whenever
    the credit standing of the borrower and/or the collateral do not
    provide adequate protection."); Jyrki Niskanen & Mervi Niskanen,
    *Covenants and Small Business Lending: The Finnish Case*, 23 [Small
    Bus. Econ.]{.smallcaps} 137, 137 (2004) (observes that the norm in
    bank loan agreements in the U.S. is to include covenants).

[^46]: *But cf. infra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text (explaining why
    hedge funds, as operated in today's market environment, may pose
    greater risk potential than other types of business organizations).

[^47]: There is, however, dissent within the SEC over whether the
    "retailization" of hedge funds is increasingly exposing ordinary
    people to hedge-fund risk. Amie Filipchuk, *Developments in Banking
    and Financial Law: 2004: IX. Securities: C. The Securities and
    Exchange Commission\'s Registration Requirement for Hedge Fund
    Advisers* 24 [Ann. Rev. Banking & Fin. L]{.smallcaps}. 189, 191,
    194--95 (2005).

[^48]: Section 4(2) of the Securities Act, 15 U.S.C. § 77d(2) (2004),
    exempts from the registration-statement and prospectus requirements
    of Section 5 of that Act "transactions by an issuer not involving
    any public offering." This exemption has been interpreted to include
    a variety of different transactions where---taking into account the
    number of offerees, their relationship to each other and to the
    issuer, the number of units offered, and the manner of the
    offering---the SEC considers there is little benefit or no practical
    need for regulation. *See* [L. Loss & J. Seligman]{.smallcaps},
    [Fundamentals of Securities Regulation]{.smallcaps} 395 (5th ed.
    2004).

[^49]: *See supra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text (describing LTCM's
    billions of dollars of exposure). *See also* [President's Working
    Group,]{.smallcaps} *supra* note Error: Reference source not found,
    at [2 (]{.smallcaps}comparing hedge funds to "other large highly
    leveraged financial institutions" in terms of their "potential to
    disrupt the functioning of financial markets"); Roger Ferguson &
    David Laster, *Hedge Funds and Systemic Risk*, [Fin. Stability
    Rev]{.smallcaps}., issue no. 10 (Apr. 2007), at 45, 51 (arguing that
    the failure of Amaranth, unlike the case of LTCM, "posed little
    systemic risk because \[the losses\] occurred in a relatively small
    and isolated market")[.]{.smallcaps}

[^50]: This "size matters" observation would apply not only to a single
    large hedge fund but also to multiple hedge funds adopting a similar
    investment strategy ("convergence") that, collectively, are large.
    *Cf.* Anthony Murphy, Managing Director, Citi Markets and Banking,
    Remarks at the International Insolvency Institute seventh annual
    conference's panel, "Understanding Derivatives: Dissecting Complex
    Financial Instruments," June 12, 2007 (on file with author).

[^51]: Sometimes, also, poor management controls can make hedge funds
    more "fragile" than other institutions. *Cf*. [President's Working
    Group,]{.smallcaps} *supra* note Error: Reference source not found,
    at [5 (]{.smallcaps}observing that hedge funds sometimes take on
    "structured or illiquid positions whose full value cannot be
    realized in a quick sale," potentially making them "somewhat fragile
    institutions" compared to other trading institutions because they
    are more vulnerable to "liquidity shocks"). Even though banks and
    securities firms sometimes take similar illiquid positions, "those
    organizations and their parent firms often have both liquidity
    sources and independent streams of income from other activities that
    can offset the riskiness of their positions." *Id.*

[^52]: *See supra* note Error: Reference source not found.

[^53]: *See supra* note Error: Reference source not found.

[^54]: \[cite\]

[^55]: *Cf.* note Error: Reference source not found and accompanying
    text.

[^56]: *See infra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text.

[^57]: Campbell R. Harvey's Hypertextual Finance Glossary, at
    http://www.duke.edu/%7Echarvey/Classes/wpg/bfgloss.htm#systematic_risk.
    *See also* Bordo et al., *supra* note Error: Reference source not
    found, at 8 (referring to this as the "financial fragility"
    approach). In an expanding market, for example, optimism accelerates
    as investors reach a state of over-indebtedness, followed by
    insufficient cash flows to service liabilities. Distressed selling
    may then occur. These inevitable market fluctuations appear to be
    systematic, not systemic, although they sometimes might trigger
    systemic problems. *Id* at 10.

[^58]: \[cite\] *But cf.* Bordo et al., *supra* note Error: Reference
    source not found, at 9 (discussing how normal market expansions and
    contractions can turn into market crises in situations of
    "speculative mania").

[^59]: Although scholars also view regulation through public choice
    theory, that is not a normative goal but, rather, merely a
    descriptive explanation of what actually occurs. Public choice
    theory views regulation as the outcome of the efforts of interest
    groups, politicians, and bureaucrats to use the political process
    for their own personal benefit, generating regulations in the
    absence of market failures. [Richard J. Herring & Robert E. Litan,
    Financial Regulation in the Global Economy]{.smallcaps} 82 (1995).

[^60]: W[. Kip Viscusi, John M. Vernon, & Joseph E. Harrington, Jr.,
    Economics of Regulation and Antitrust 9]{.smallcaps} (3d ed. 2000)
    (arguing that, where health and safety are not at issue, the
    rationale for regulatory policy is "foster\[ing\] improvements
    judged in efficiency terms"); Gillian Hadfield, Privatizing
    Commercial Law: Lessons from the Middle and the Digital Ages 58
    (Mar. 2000) (unpublished manuscript, available at
    http://papers.ssrn.com/sol3/delivery.cfm/000329600.pdf?abstractid=220252)
    (arguing that the "public value at stake in relationships between
    commercial entities . . . is economic efficiency").

[^61]: [Thomas Lee Hazen, The Law of Securities Regulation]{.smallcaps}
    9 (3d ed. 1996). *See also* John C. Coffee, Jr., *Market Failure and
    the Economic Case for a Mandatory Disclosure System*, 70 [Va. L.
    Rev]{.smallcaps}. 717, 751-52 (1984) (arguing that the strongest
    arguments for the mandatory disclosure system under securities law
    are based on efficiency); [George J. Stigler, The Citizen and the
    State]{.smallcaps} 88 (1975) (arguing that economic efficiency
    *should be* the central goal of the U.S. securities laws because
    "efficient capital markets *are* the major protection of investors")
    (emphasis in original). Although some have suggested that fairness
    is also an important goal of securities regulation, fairness might
    only be relevant in this context as a means of achieving efficiency.
    *See, e.g., The Bond Price Competition Improvement Act of 1999:
    Hearing Before the Subcomm. on Finance and Hazardous Materials of
    the House Comm. on Commerce*, 106^th^ Cong. 9 (1999) (statement of
    Hon. Arthur Levitt, Chairman, Securities and Exchange Commission)
    (testifying that "\[i\]nformed investors, armed with accurate
    information, ensure that market prices represent fair values. And
    fair market prices, in turn, ensure that the markets perform their
    economic function of efficiently allocating capital resources").

[^62]: [Hal S. Scott & Philip A Wellons, International
    Finance]{.smallcaps} 46 (7^th^ ed. 2000) (arguing that the goal of
    securities law is to "develop a global regulatory framework that
    preserves the efficiencies associated with international capital
    mobility").

[^63]: [Hendrik S. Houthakker & Peter J. Williamson, The Economics of
    Financial Markets]{.smallcaps} 285 (1996). *See also* [David
    Gowland, The Regulation of Financial Markets in the
    1990s]{.smallcaps} 21 (1990); [Herring & Litan,]{.smallcaps} *supra*
    note Error: Reference source not found, at 79. Regulating markets to
    correct market failure is sometimes referred to as the "public
    interest theory." [Gowland,]{.smallcaps} *supra* at 21.

[^64]: *See* [President's Working Group]{.smallcaps}*, supra* note
    Error: Reference source not found, at 31.

[^65]: *See* Rodrigo Cifuentes, Gianluigi Ferrucci, & Hyun Song Shin,
    *Liquidity Risk and Contagion* 17-18 (working paper, Jan. 19, 2004,
    on file with author) (observing that "when choosing their portfolio
    allocation banks do not internalise the positive externalities that
    holding more liquidity has on the stability of the system.
    Therefore, the privately determined liquidity will be
    sub-optimal.").

[^66]: *See infra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text (discussing the
    social impact of a systemic collapse of the financial system).

[^67]: Hardin, *supra* note Error: Reference source not found.

[^68]: *See infra* note Error: Reference source not found and
    accompanying text.

[^69]: In other words, individual market participants may choose to act
    selfishly because their returns are assured whereas a systemic
    collapse is not necessarily inevitable. LTCM, for instance, knew
    there was a risk of failure if the markets became irrational but
    chose to trust models that made them money.
    [Lowenstein,]{.smallcaps} *supra* note Error: Reference source not
    found, at 71--75, 173. Ignoring a possible greater risk for the sake
    of personal gain is not unique to the world of finance. Before the
    *Challenger* disaster, engineers knew of the risk that the rubber
    O-rings might fail at cold temperature and argued that the launch
    should be delayed until warmer weather. Engineers also identified
    the potential for wing damage before the *Columbia* disaster. In
    both cases, however, NASA administrators appeared to have been less
    concerned about the possible safety risks than about the impact on
    their personal reputations of canceling flights. [Richard
    Bookstaber, A Demon of Our Own Design: Markets, Hedge Funds, and the
    Perils of Financial Innovation 159--61 (2007).]{.smallcaps}

[^70]: *Cf.* Cifuentes et al., *supra* note Error: Reference source not
    found, at 18 (observing that because banks do not internalize
    externalities regarding financial-system stability, liquidity and
    capital requirements "need to be externally imposed"). The need for
    regulation must be balanced, of course, by its cost. The extent to
    which the benefits of systemic-risk regulation exceed its costs, and
    the extent to which such regulation is more cost effective when
    implemented on an ex ante preventative or ex post reactive basis, is
    discussed *infra* Parts III.C and III.D.

[^71]: I thank my colleague, Ralf Michaels, for this insight into
    differentiating risks within, and to, the financial system.

[^72]: The widespread poverty and unemployment caused by the Great
    Depression, for example, apparently fostered a significant increase
    in crime. *See* Jeffrey L. Kirchmeier, *Another Place Beyond Here:
    The Death Penalty Moratorium Movement in the United States,* 73 U.
    COLO. L. REV. 1, 11 (Winter 2002) (discussing an explosion of
    executions as probably resulting from increased crime due to the
    Great Depression). *Cf.* Erin Ryan, *Federalism and the Tug of War
    Within: Seeking Checks and Balance in the Interjurisdictional Gray
    Area*, 66 MD. L. REV. 503, 636-37 (2007) ("pragmatism . . . seems
    well-suited to the circumstances of the time: massive unemployment,
    farmer uprisings and hunger marches, public rioting, and widespread
    fear of revolt.").

[^73]: [Viscusi et al.,]{.smallcaps} *supra* note Error: Reference
    source not found, at 9.

[^74]: *See* Department of Homeland Security, Pandemic Influenza:
    Preparedness, Response, and Recovery, Guide for Critical
    Infrastructure and Key Resources, *available at*
    http://www.pandemicflu.gov/plan/pdf/CIKRpandemicInfluenzeGuide.pdf.

[^75]: Critical industry sectors are broken down into critical
    infrastructure and key resources. Critical infrastructure is defined
    as systems and assets so vital to the U.S. that their incapacity or
    destruction would have a debilitating impact on security, national
    economic security, national public health, safety, or any
    combination of those. *Id.* at 20. Critical infrastructure is
    identified as banking and finance, food and agriculture, national
    monuments and icons, chemical and hazardous materials, defense
    industrial base, water, public health and healthcare, energy,
    emergency services, information technology, telecommunications,
    postal and shipping, and transportation. *Id.* at 7. Key resources
    are identified as commercial facilities, government facilities,
    dams, and nuclear power plants. *Id*.

[^76]: *Id.* at 20. DHS is concerned that a pandemic, by disturbing
    these industry sectors, might cause "economic disruption" and
    "social disturbance." *Id.* at 32.

[^77]: This is not to say that preserving the financial system will
    always be socially optimal. An iconoclast might contend that
    collapse of the financial system could, in the long run, sometimes
    be beneficial for society, such as by redistributing wealth
    (although there is no assurance how wealth would be redistributed,
    and it is likely that overall wealth would be much diminished). Even
    the Great Depression arguably resulted in some desirable changes,
    such as social security, that might not otherwise have been
    politically feasible. *But cf*. Milton Friedman, *Social Security
    Chimeras*, [N.Y. Times]{.smallcaps}, Jan. 11, 1999 at A17 (finding
    it "hard to justify requiring 100 percent of the people to adopt a
    government-prescribed \[social security\] straitjacket").

[^78]: Another way to view stability as a goal of systemic-risk
    regulation derives from the recognition that, in matters of health
    and safety, increasing social well-being and not economic efficiency
    alone is generally understood to be the goal of regulation. Because
    it is difficult to identify non-efficiency goals for traditional
    financial regulation (*cf.* Steven L. Schwarcz, *Private Ordering*,
    97 [Nw. U. L. Rev]{.smallcaps}. 319, 331-32 (2002)), it might seem
    that any ultimate inquiry into consequences would require empirical
    testing and, to some extent, may be more of a political than a legal
    determination. In the case of systemic risk, however, the answer may
    be more straightforward: the non-efficiency goals should be those
    needed to prevent systemic risk's devastating consequences to health
    and safety. It is these consequences, not the inherent nature of
    systemic risk per se, that makes the question of regulating systemic
    risk most important. *Cf.* [Richard A. Posner, Law, Pragmatism, and
    Democracy]{.smallcaps} (2003) (arguing for pragmatism by paying
    attention to consequences, and contending this is more important
    than legal formalism or seeking high principles); Yamaguchi, *supra*
    note Error: Reference source not found (also considering
    consequences). These consequences can be prevented, however, by
    preventing the collapse of the financial system.

[^79]: Although I recognize that efficiency, in a broad sense, includes
    not only health and safety (*see* *supra* note Error: Reference
    source not found and accompanying text) but also stability, it will
    be analytically useful to view stability as separate from efficiency
    per se.

[^80]: *See, e.g.,* [John Eatwell & Lance Taylor, Global Finance at
    Risk]{.smallcaps} 19 (2000): "\[R\]egulation can be expensive and
    oppressive or even downright wrongheaded. Overly fastidious
    regulation may result in risks being *over*priced, and hence will
    stifle enterprise. . . . A balance needs to be struck . . . ." *See
    also* [Edith Stokey & Richard Zeckhauser, A Primer for Policy
    Analysis]{.smallcaps} 309-10 (1978) (warning that "the history of
    \[government\] interventions to deal with market failure is a
    history of disappointments \[and hence one\] should recognize that
    market failure does not mandate government intervention; it just
    suggests the possibility that such intervention might prove
    beneficial"). *Cf.* Steven L. Schwarcz, *The Easy Case for the
    Priority of Secured Claims in Bankruptcy*, 47 [Duke]{.smallcaps} L.
    J. 425, 476 n. 225 (1997) (discussing the ability of market
    participants, in this case lenders, to find alternative markets; in
    the case of systemic risk, however, shifting investments to foreign
    markets (capital flight) would harm the domestic economy).
    Regulation also can be misguided or counterproductive, sometimes
    even conflating cause and effect. *Cf.* [Posner,]{.smallcaps}
    *supra* note Error: Reference source not found, at 456 (observing
    that securities market regulation is "founded on the premise that
    without such regulation \[such markets\] would not function
    satisfactorily," but then arguing, *id.* at 457, that this premise
    "is rooted in part in a misconception about the great depression of
    the 1930s"---the misconception being the natural tendency to think
    of the 1929 stock market crash as resulting from abuses and, in
    turn, being a cause of the depression, whereas a precipitous decline
    in stock prices is more likely to result from the expectation of a
    decline in economic activity).

[^81]: Even where there is market failure, "government intervention may
    not \[always\] yield a superior outcome." [Viscusi et
    al.,]{.smallcaps} *supra* note Error: Reference source not found, at
    [10]{.smallcaps}. *See also id.* at 13 (observing that "'government
    failure' may be of the same order of importance as market failure").

[^82]: *See, e.g.,* D. T. Llewwllyn, *Competition and the Regulatory
    Mix*, [Nat'l Westminster Bank Q. Rev.,]{.smallcaps} Aug. 1987, at
    4-5. *See also* [Eatwell & Taylor,]{.smallcaps} *supra* note Error:
    Reference source not found, at 19 (observing that overly fastidious
    regulation may result in risks being overpriced).

[^83]: The term "moral hazard" has various related meanings. In the
    insurance context, in which the term arose, it means "the deliber­ate
    efforts by the insured to bring about the insured event, as when the
    owner of life insurance commits suicide." Richard A. Epstein,
    *Products Liability as an Insurance Market*, 14 [J. Legal
    Stud.]{.smallcaps} 645, 653 (1985). *See generally* Steven Shavell,
    *On Moral Hazard and Insurance*, 93 [Q.J. Econ.]{.smallcaps} 541
    (1979) (providing an economic analysis of the standard of care for
    the insured in the moral hazard context). In a more general economic
    context, however, the term simply refers to the greater tendency of
    people who are protected from the consequences of risky behavior to
    engage in such behavior. *See* Charles G. Hallinan, *The "Fresh
    Start" Policy in Consumer Bankruptcy: A Historical Inventory and an
    Interpretive Theory*, 21 [U. Rich. L. Rev.]{.smallcaps} 49, 84
    (1986) (relying on the economic definition of moral hazard: debtors
    and creditors that are protected from the consequences of default
    "could be expected to increase both excessive borrowing and
    excessive resort to bankruptcy").

[^84]: [Gowland,]{.smallcaps} *supra* note Error: Reference source not
    found, at 21.

[^85]: In a non-financial context, an example would be government aid
    (somewhat analogous to bailout loans) to flood-plain homeowners that
    encourages those homeowners to re-build in the flood plain. Robert
    McLeman & Barry Smit[,]{.smallcaps} *Vulnerability to Climate Change
    Hazards and Risks: Crop and Flood Insurance*, 50 [Can.
    Geographer]{.smallcaps} 217 *passim* (2006).

[^86]: For example, regulation that is a knee-jerk political reaction to
    market failure may be unnecessary and, to the extent the market
    naturally adjusts to information that caused its failure,
    counterproductive. According to the late Milton Friedman, the
    government's policy of contracting the capital supply in the banking
    market exacerbated the severity of the Great Depression. He asserted
    that the capital contraction was born of economic regulators'
    tendency to react to crises unadvisedly. Milton Friedman, *Have
    Monetary Policies Failed?,* 62 [Am. Econ. Rev.]{.smallcaps} 11, 12
    (May 1972) ("There was no need for monetary authorities to permit a
    decline of one-third in the quantity of money. They could have
    prevented a decline and produced an increase. If they had, I do not
    believe the great depression would have occurred. In that sense,
    monetary policy failed."). *See also* Francis A. Bottini, *An
    Examination of the Current Status of Rating Agencies and Proposals
    for Limited Oversight of Such Agencies,* 30 [San Diego L.
    Rev]{.smallcaps}. 579, 610-11 (1993) (observing that "\[t\]oo much
    regulation inhibits economic growth by increasing costs and making
    capital harder to raise").

[^87]: *See supra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text.

[^88]: Whether efficiency should also be judged by whether the financial
    system being stabilized is itself efficient is beyond the scope of
    this article, which assumes for analysis purposes that the existing
    financial system is efficient and thus preserving it is a public
    good. *See supra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text (discussing whether
    collapse of the financial system sometimes could, in the long run,
    be beneficial for society).

[^89]: *See* [Richard A. Posner, Economic Analysis of Law]{.smallcaps}
    § 1.2, at 13-14 (4th ed. 1992) (discussing this "Kaldor-Hicks"
    standard as the operating standard of efficiency). *Accord,* Louis
    Kaplow & Steven Shavell, *Fairness Versus Welfare*, 114 [Harv. L.
    Rev]{.smallcaps}. 961, 1015 (2001).

[^90]: *See infra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text (computing the
    cost-benefit efficiency of regulating systemic risk by separately
    recognizing *R*, the cost of regulation).

[^91]: Yamaguchi, *supra* note Error: Reference source not found, at 2.

[^92]: Steven A. Ramirez, *The Law and Macroeconomics of the New Deal*,
    62 MD. L. REV. 515, 543-44 (2003).

[^93]: [Eichberger & Summer]{.smallcaps}, *supra* note Error: Reference
    source not found[,]{.smallcaps} at [1; Davis,]{.smallcaps} *supra*
    note Error: Reference source not found, at 124-26.

[^94]: Basel II outlines credit risk, operational risk, and market risk
    as the three issues which should influence capital holding
    requirements. [Basel Committee on Banking Supervision, International
    Convergence of Capital Measurement and Capital Standards: A Revised
    Framework]{.smallcaps} 26-217 (June 2006), *available at*
    http://www.bis.org/publ/bcbs128.pdf. The benefits of Basel II are
    said to include greater transparency and a "state of the art"
    approach to risk management that "make banking safer and more
    profitable." [Marc B. Lambrecht, The Basel II Rating: Ensuring
    Access to Finance Your Business]{.smallcaps} 9 (2005). *See also*
    Jaime Caruana *in* [C.E.V. Borio]{.smallcaps}, [Market Discipline
    Across Countries and Industries]{.smallcaps} 25 (2004).

[^95]: Kaufman, *supra* note Error: Reference source not found, at 5.
    *See also id.* at 18 (quoting Anna Schwartz). *Cf.*
    [Posner,]{.smallcaps} *supra* note Error: Reference source not
    found, at 461 (arguing that the widespread bank failures during the
    1930s were "thought, perhaps erroneously, to have been an important
    cause of the severity of the business contraction," resulting in
    excessive banking regulation).

[^96]: Kaufman, *supra* note Error: Reference source not found, at 6.

[^97]: *Id.*

[^98]: *Id.*

[^99]: *See* Jane D'Arista, *Financial Regulation in a Liberalized
    Global Environment*, in [International Capital Markets: Systems in
    Transition]{.smallcaps} 75, 76 (John Eatwell & Lance Taylor eds.,
    2002) (discussing reciprocal flight of American and British banking
    activity to avoid domestic regulation).

[^100]: [Eichberger & Summer]{.smallcaps}, *supra* note Error: Reference
    source not found[,]{.smallcaps} at 22 (arguing that "\[b\]anks which
    face a binding capital adequacy constraint and whose firms are
    successful will end up with positive, but lower equity value than in
    a situation without regulation. Thus, in the following period, they
    are likely to be constrained again. Hence, capital adequacy
    constraints affect\[\] also the capacity of banks to build up equity
    value.").

[^101]: Frank Partnoy, *Why Markets Crash and What Law Can Do About It*,
    61 U. PITT L. REV. 741, 781-82 (Spring 2000) (arguing that bank
    capital adequacy requirements are "seriously flawed" because their
    heavy reliance on credit ratings leads to inaccuracies, banks are
    able to use derivatives to add risk in ways that these requirements
    do not take into account, and such requirements also "rely on
    short-term measures of \[earnings\] volatility that do not capture
    the risks of bank failure").

[^102]: *See* [President's Working Group,]{.smallcaps} *supra* note
    Error: Reference source not found, at [29-43]{.smallcaps}.

[^103]: Bernanke, *supra* note Error: Reference source not found, at 2-4
    (observing that although, "provisional\[ly\]," the recommendations
    of the [President's Working Group]{.smallcaps} "apparently have been
    effective" in that hedge-fund failures have not, "for the most
    part," resulted in losses to creditors and counterparties and there
    is a "general perception among market participants . . . that hedge
    funds are less highly leveraged" (though noting the possibility of
    non-transparent leverage), "some concerns about counterparty risk
    management remain and may have become even more pronounced given the
    increasing complexity of financial products" and the fact that
    "hedge funds have greatly expanded their activities and
    strategies"). Subsequent to Bernanke's report, a consensus has
    arisen---*contrary to the "general perception" Bernanke refers to
    above*---that hedge funds are now much more highly leveraged than
    ever. *See, e.g.*, Randall Smith & Susan Pulliam, *Outer Limits: As
    Funds Leverage Up, Fears of Reckoning Rise*, [Wall St.
    J.,]{.smallcaps} Apr. 30, 2007, at A1.

[^104]: [U.S. General Accounting Office]{.smallcaps}, *supra* note
    Error: Reference source not found.

[^105]: Mara der Hovanesian, *The SEC Isn't Finished with Hedge Funds*,
    [Bus. Wk]{.smallcaps}. 34 (July 17, 2006).

[^106]: For additional non-systemic problems that might be the province
    of SEC regulation, *see* Paredes, *supra* note Error: Reference
    source not found, at 6-7.

[^107]: *See*, *e.g.,* Chan et al., *supra* note Error: Reference source
    not found; Timothy F. Geithner, *Hedge Funds and Their Implications
    for the Financial System*, Federal Reserve Bank of New York (Nov.
    17, 2004); [President's Working Group,]{.smallcaps} *supra* note
    Error: Reference source not found; *Toward Greater Financial
    Stability: A Private Sector Perspective*, Counterparty Risk
    Management Group II (2005) (all of these articles, from the economic
    and financial literature, recognizing systemic risk as *the* central
    issue of hedge fund failure).

[^108]: Paredes, *supra* note Error: Reference source not found, at 21.
    *Accord*, Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).

[^109]: *See* Greg Ip, Robin Sidel & Randall Smith, *Stronger Steps: Fed
    Offers Banks Loans to Ease Credit Crisis*, [Wall St]{.smallcaps}.
    J., Aug. 18-19, 2007, Weekend Ed., at A1;
    http://www.duke.edu/%7Echarvey/Classes/wpg/bfglosd.htm (visited Aug.
    20, 2007).

[^110]: Smith, Mollenkamp, Perry, & Ip, *supra* note Error: Reference
    source not found, at A8.

[^111]: Ip, Sidel, & Smith, *supra* note Error: Reference source not
    found, at A8 (observing that "the \[Fed's\] discount window's reach
    in the current crisis is limited by the fact that only banks can use
    it, and they aren't the ones facing the greatest strains").

[^112]: *See infra* note Error: Reference source not found (observing
    that because financial markets are tightly coupled, spiraling events
    may well occur rapidly, within days). *Cf.* Seth Carpenter & Selva
    Demiralp, *The Liquidity Effect in the Federal Funds Market:
    Evidence from Daily Open Market Operations*, 38 [J.
    Money]{.smallcaps} [Credit & Banking]{.smallcaps} 901, 918-919
    (2006) (concluding that although a change in monetary policy can
    begin to affect the cost of capital within a day, its full effects
    can take much longer); Serena Ng, Greg Ip, & Shefali Anand, *Fed
    Fails So Far In Bid to Reassure Anxious Investors*, [Wall
    St]{.smallcaps}. J., Aug. 21, 2007, at A1.

[^113]: For an in-depth analysis of the sub-prime mortgage crisis, its
    impact on financial markets, and its application to the principles
    discussed in this article, *see* Steven L. Schwarcz, "Systemic Risk
    in Financial Markets: Lessons from the Sub-Prime Mortgage Meltdown"
    (forthcoming).

[^114]: *See supra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text.

[^115]: *Cf.* *supra* note Error: Reference source not found and
    references therein.

[^116]: *Cf.* *supra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text.

[^117]: *See, e.g.,* [Davis,]{.smallcaps} *supra* note Error: Reference
    source not found, at 127-28 (describing how markets are depressed
    when failing institutions are forced by creditors to liquidate their
    assets in distress sales). *See also infra* note Error: Reference
    source not found and accompanying text (discussing how forced sales
    of assets to meet margin calls can depress asset prices, creating a
    downward pricing spiral); Cifuentes et al., *supra* note Error:
    Reference source not found, at 5-6 (noting the "recent theoretical
    findings on banking and financial crises that has emphasised the
    limited capacity of the financial markets to absorb sales of
    assets").

[^118]: These spiraling events may well occur rapidly, within days.
    *See, e.g.*, Testimony of Richard Bookstaber before the U.S. House
    of Representatives Committee on Financial Services, Oct. 2, 2007, at
    1 (observing the "tendency for the markets to move rapidly into a
    crisis mode," and referring to this tendency, by analogy to
    engineering, as "tight coupling"), available at
    http://www.house.gov/apps/list/hearing/financialsvcs_dem/ht1002072.shtml.
    *See also* Michael Mandel, *The Economy's Safety Valve*, [Bus.
    Wk]{.smallcaps}., Oct. 22, 2007, at 34, 37 (quoting Professor Barry
    Eichengreen that "\[t\]he different components of the financial
    system are tightly linked to each other").

[^119]: [Milton Friedman & Anna Schwartz,]{.smallcaps} [A Monetary
    History of the United States 1867-1960,]{.smallcaps} at 311
    [(1963).]{.smallcaps} Such a panic can occur, for example, when
    depositors "fear that means of payment will be unobtainable at any
    price." Bordo et al, *supra* note Error: Reference source not found,
    at 7.

[^120]: *Deposit Insurance*, Hearing Before the U.S. Senate Committee on
    Banking, Housing, and Urban Affairs, Feb. 26, 2003 (statement of
    Alan Greenspan, Chairman of the U.S. Federal Reserve System),
    *available at*
    http://www.federalreserve.gov/boarddocs/testimony/2003/20030226/default.htm.

[^121]: *See* [Davis,]{.smallcaps} *supra* note Error: Reference source
    not found, at 121.

[^122]: *See supra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text.

[^123]: To some extent this vicious cycle is exacerbated by the common
    requirement that a securities account be adjusted in response to a
    change in the market value of the securities. An investor, for
    example, may buy securities on credit from a securities
    broker-dealer, securing the purchase price by pledging the
    securities as collateral. To guard against the price of the
    securities falling to the point where their value as collateral is
    insufficient to repay the purchase price, broker-dealer requires the
    investor to maintain a minimum collateral value. If the market value
    of the securities falls below this minimum, the broker-dealer will
    issue a "margin call" requiring the investor to deposit additional
    collateral, usually in the form of money or additional securities,
    to satisfy this minimum. Failure to do so triggers a default,
    enabling the broker-dealer to foreclose on the collateral. [Zvi
    Bodie, Alex Kane & Alan J. Marcus, Investments]{.smallcaps} 78-79
    (7th ed. 2008). Requiring investors to "mark-to-market" in this
    fashion is generally believed to reduce systemic risk. *See, e.g.,*
    Gikas A. Hardouvelis & Panayiotis Theodossiou, *The Asymmetric
    Relationship Between Initial Margin Requirements and Stock Market
    Volatility Across Bull and Bear Markets*, 15 [Rev. Fin.
    Stud.]{.smallcaps} 1525, 1554--55 (2002) (finding a correlation
    between higher margin calls and decreased systemic risk, and
    speculating that higher margin calls may bleed the irrationality out
    of the market until only sound bets are left). Nonetheless, it can
    cause "perverse effects on systemic stability" during times of
    market turbulence, when forcing sales of assets to meet margin calls
    can depress asset prices, requiring more forced sales (which, in
    turn, will depress asset prices even more), causing the downward
    spiral. " Cifuentes et al., *supra* note Error: Reference source not
    found, at 2. *See also* Clifford De Souza & Mikhail Smirnov,
    *Dynamic Leverage: A Contingent Claims Approach to Leverage for
    Capital Conservation*, J. Portfolio Mgmt., Fall 2004, at 25, 28
    (arguing that, in a bad market, short-term pressure to sell assets
    to raise cash for margin calls can lead to further mark-to-market
    losses for remaining assets, which triggers a whole new wave of
    selling, the process repeating itself until markets improve or the
    firm is wiped out; and referring to this process as a Critical
    Liquidation Cycle). The existence of leverage makes this cycle more
    likely and amplifies it if it occurs. *Id.* at 26-27 (also
    explaining, *id*. at 37, that leverage decreases the amount of
    capital relative to potential cash obligations, and the Critical
    Liquidation Cycle begins whenever this equity falls below the level
    necessary to meet the firm's obligations and equity cannot be raised
    by selling assets without incurring losses).

[^124]: *Cf.* Andrew Elek & Dominic Wilson, *The East Asian Crisis and
    International Capital Markets*, [Asian-Pacific Econ.
    Literature]{.smallcaps} 1, 7 (May 1999) (describing investor
    withdrawal of capital and resulting large-scale insolvency due to
    market illiquidity).

[^125]: *See, e.g.,* Partnoy, *supra* note Error: Reference source not
    found, at 782-83 (characterizing this approach as a "circuit
    breaker"). Capital markets in the United States, for example, were
    closed for this purpose following the 911 attacks. Margo McCall,
    *Uncertainty Follows Tragedy*, [Wireless Week]{.smallcaps}, Sep. 17,
    2001, at 1.

[^126]: Partnoy, *supra* note Error: Reference source not found, at 783
    (arguing that closing down markets "may actually fuel panic," and
    explaining that "there is no empirical evidence supporting this
    point, but it seems equally plausible that investor cognitive error
    would increase more during the period in which the circuit breaker
    \[closing down the market\] is in effect than it would have
    increased during a period of panic selling"). \[Consider also any
    lessons to be gleaned from governmental reports of responses to the
    1987 worldwide stock market drop break, in which the U.S. SEC
    Chairman (David Ruder) decided not to close the New York Stock
    Exchange but the Hong Kong stock market was closed by regulators.
    Professor Cox argues that the NYSE subsequently thrived, but it took
    years for the HK stock market's trading volume to return. cite\]

[^127]: *See* Eduardo Porter, *Shanghai What-if: How a Shock Can Become
    a Shock Wave*, N.Y. [Times]{.smallcaps}, Mar. 4, 2007, at WK3
    (quoting observation by Alan Blinder, Princeton University economist
    and former Vice Chairman, Board of Governors, U.S. Federal Reserve
    System).

[^128]: *Cf.* [Davis,]{.smallcaps} *supra* note Error: Reference source
    not found, at 12 (observing that mispricing can lead to increased
    market vulnerability); Bordo et al., *supra* note Error: Reference
    source not found, at 9 (discussing how "speculative mania" can turn
    into market crisis).

[^129]: *Cf.* [Posner,]{.smallcaps} *supra* note Error: Reference source
    not found, at 446 (observing that investors, who are risk averse,
    will want to be compensated for risk that cannot be eliminated).

[^130]: Paul Krugman, Editorial, *The Big Meltdown*, N.Y.
    [Times]{.smallcaps}, Mar. 2, 2007, at A17.

[^131]: *Id.* Internationally, the decline in the risk premium has been
    even more pronounced, with high-yield European bonds commanding
    nearly 16% interest in 2002 but recently less than 3%. Ravi
    Balakrishnan et al., *Globalization, Gluts, Innovation or
    Irrationality: What Explains the Easy Financing of the U.S. Current
    Account Deficit?* 12 (Int'l Monetary Fund, IMF Working Paper No.
    07/160, July 2007).

[^132]: Balakrishnan argues that the decline in the risk premium is due
    to a liquidity glut. *See id.* A participant in a faculty workshop
    suggested, anecdotally, that the decline might result from hedging,
    whereby risk gets spread out (*cf. infra* notes Error: Reference
    source not found-Error: Reference source not found and accompanying
    text, discussing hedging), risk-spreading would not appear to have
    more than a marginal effect on risk premiums. In the face of actual
    risk, well-informed hedging parties would themselves price in the
    risk and thereby require that amount to be paid as consideration by
    the hedged parties. The hedged parties, in turn, would have to pay
    that price out of the risk premium. This appears no different than
    banks diversifying risk through the sale of loan participations
    (*see* Steven L. Schwarcz, *Intermediary Risk in a Global Economy*,
    50 [Duke L. J.]{.smallcaps} 1541, 1557-61 (2001), discussing loan
    participations), which does not significantly reduce the risk
    premium for borrowers since buyers of loan participations demand
    compensation for the portion of the risk they are assuming. This
    article later argues that spreading risk may well reduce systemic
    risk by reducing the chance that any given default will cause a
    chain of institutions to fail (*see infra* note Error: Reference
    source not found and accompanying text), but it should not reduce
    risk *within* the financial system.

[^133]: Under the availability heuristic, people overestimate the
    frequency or likelihood of an event when examples of, or
    associations with, similar events are easily brought to mind. For
    example, people typically overestimate the divorce rate if they can
    quickly find examples of divorced friends. Paul Slovic, Baruch
    Fischhoff & Sarah Lichtenstein, *Facts Versus Fears: Understanding
    Perceived Risk*, *in* [Judgment under Uncertainty: Heuristics and
    Biases]{.smallcaps} 463, 465 (Daniel Kahneman et al. eds., 1982).

[^134]: Krugman, *supra* note Error: Reference source not found.

[^135]: *See, e.g.,* [Thomas Cargill, et al., The Political Economy of
    Japanese Monetary Policy]{.smallcaps} 108 (date) (discussing this
    behavior and explaining that even when investors believe prices are
    abnormally high, they may invest further under the assumption that
    prices will rise for some time and they will be the first to sell
    before prices fall).

[^136]: *Cf.* Steven L. Schwarcz, *Rethinking the Disclosure Paradigm in
    a World of Complexity*, 2004 U. [Ill. L. Rev.]{.smallcaps} 1, 14
    (discussing this phenomenon).

[^137]: A famous example of irrational investment arose out of the tulip
    trade in 17^th^ century Holland. Certain tulips were highly prized
    and sold for thousands of guilder. Almost everyone got caught up in
    the excitement of buying and selling tulip bulbs, usually on credit
    and with the intention of making a quick profit. When the market
    finally crashed, many who speculated on credit were left with
    crushing debts. Sam Segal, *Tulips Portrayed: The Tulip Trade in
    Holland in the 17th Century*, *in* [The Tulip: A Symbol of Two
    Nations]{.smallcaps} 17--20 (Michael Roding & Hans Theunissen eds.,
    1993). Irrational investment trends can start quite easily. If, for
    example, a particular stock unexpectedly gains in value, the losers
    (e.g., those shorting the stock) will tend to withdraw from that
    market and the winners will tend to increase their investment,
    driving up the price even further. Soon other winners are attracted
    to the stock and other losers cut their losses and stop shorting the
    stock. This process is aided by almost inevitable explanations of
    why it is "rational" for the price to keep going up and why the
    traditional relationship of price to earnings does not apply. Even
    investors who recognize the bubble as irrational may buy in, hoping
    to sell at the height of the bubble before it bursts. *Id.* at 181.
    In these ways, price movements can become somewhat self-sustaining.
    B[ookstaber,]{.smallcaps} *supra* note Error: Reference source not
    found, at [169]{.smallcaps}--70.

[^138]: In a banking context, some scholars argue that the degree of
    information asymmetry within a given banking system is the main
    determinant of whether a similar trigger event will lead to a small
    panic or a large one, and that systems with large or heavily
    interconnected banks are less likely, because of institutional
    system-wide self-monitoring (and correspondingly less information
    asymmetry among system participants), to experience large panics,
    whereas systems characterized by small and highly independent banks
    lack the means for effective self-monitoring. Gary Gortona & Lixin
    Huang, *Bank Panics and the Endogeneity of Central Banking*, 53 J.
    [MONETARY ECON]{.smallcaps}. 1613, 1627-28 (May 2005). Outside of
    banking, however, there is uncertainty. If a particular financial
    system is linear, like a tree of dominoes, it should be possible to
    calculate possible consequences. *See* [Bookstaber]{.smallcaps},
    *supra* note Error: Reference source not found, at 155--56. But if
    the system is non-linear, like the weather, even minute changes in
    the triggering event could lead to large macro differences in the
    outcome, making it difficult to calculate long-term consequences.
    *Id.* at 228-30.

[^139]: \[cite\]

[^140]: This collateral-value restriction on margin loans is imposed
    under Regulations G, U, T, and X \[cite\], which require a
    two-to-one collateral-value-to-loan ratio on loans to purchase
    margin (i.e., publicly-traded) stock, secured by such stock.

[^141]: Greg Lumelsky, *Does Russia Need a Securities Law?*, 18 [Nw. J.
    Int'l L. & Bus]{.smallcaps}. 111, 122-23 (Fall 1997) (observing that
    "\[s\]ince before the New Deal, the U.S. philosophy of securities
    regulation has been based on the provision of continuous, accurate,
    public disclosure as a remedy against fraud and as a way to reduce
    risk associated with the purchase and sale of securities").

[^142]: *Id.*

[^143]: *Cf. supra* note Error: Reference source not found (indicating
    that investors will want to be compensated for risk that cannot be
    eliminated).

[^144]: *See supra* note Error: Reference source not found and
    accompanying text.

[^145]: *See supra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text (likening systemic
    risk to a tragedy of the commons).

[^146]: \[cite\] \[Query the extent it would help manage systemic risk
    if government received full disclosure of such otherwise non-public
    information, even if such disclosure would not operatively reduce
    systemic risk. To this extent, government could keep the disclosed
    information confidential except as aggregate figures. Cite1\]

[^147]: Roberta Romano, *A Thumbnail Sketch of Derivative Securities and
    Their Regulation*, [55 Md. L. Rev. 1]{.smallcaps}, 80-81 (1998)
    (arguing also, in the context of the unregulated derivatives market,
    that improved disclosure would not have prevented hedge-fund
    problems).

[^148]: [Bookstaber]{.smallcaps}, *supra* note Error: Reference source
    not found, at 221.

[^149]: *See* Schwarcz, *supra* note Error: Reference source not found
    (arguing that the increasing complexity of transactions and markets
    is making disclosure less able to reduce information asymmetry, and
    that supplementary approaches should be sought to reduce such
    asymmetry).

[^150]: *Credit & Blame: How Rating Firms' Calls Fueled Subprime Mess*,
    [Wall St.]{.smallcaps} J., Aug. 15, 2007, at A1 (quoting a market
    observer). *See also* Daniel Andrews, *The Clean Up: Investors Need
    Better Advice on Structured Finance Products*, 26 [Int'l Fin. L.
    Rev.]{.smallcaps} 14, 14 (Sept. 2007) (observing that "\[i\]nvestors
    have the prospectuses to rely on, but the reality is that they have
    not taken any responsibility for reading the detail of the
    documentation or digesting the risks involved").

[^151]: *See, e.g.,* [Lowenstein,]{.smallcaps} *supra* note Error:
    Reference source not found, at xix & 231 (arguing that derivatives
    are too complex for regulators to understand the extent of the risks
    they create, and that disclosure alone will not enable investors to
    understand the risks).

[^152]: Adam R. Waldman, Comment, *OTC Derivatives & Systemic Risk:
    Innovative Finance or the Dance into the Abyss?*, 43 [Am. U. L.
    Rev.]{.smallcaps} 1023, 1055--56 (1994). \[Why is there 1,000x
    leverage, and should leverage be regulated per the discussion below
    of limiting leverage? Cite1\]

[^153]: For an analysis of that larger debate, *see* Romano, *supra*
    note Error: Reference source not found.

[^154]: *See, e.g.,* Michel Aglietta, *Financial Market Failures and
    Systemic Risk* 7--12, 15--26 (Centre d'études prospectives et
    d'informations internationales, Working Paper No. 1996--01, 1996);
    Michael R. Darby, *Over-The-Counter Derivatives and Systemic Risk to
    the Global Financial System* 6--18 (Nat'l Bureau of Econ. Res.,
    Working Paper No. 4801, 1994); Ludger Hentschel & Clifford W. Smith,
    Jr., *Risks in Derivatives Markets: Implications for the Insurance
    Industry*, 64 [J. Risk & Ins.]{.smallcaps} 323, 342 (1997); Frank
    Partnoy & David A. Skeel, Jr., *The Promise and Peril of Credit
    Derivatives*, 75 [U. Cin. L. Rev]{.smallcaps}. 1019, 1040 (2007)
    (all arguing that derivatives can increase risk if they are used for
    speculation rather than hedging). *But cf.* Ludger Hentschel &
    Clifford W. Smith, Jr., *Derivatives Regulation: Implications for
    Central Banks*, 40 [J. Mon. Econ]{.smallcaps}. 305, 320--23 (1997) &
    Myron S. Scholes, *Global Financial Markets, Derivatives Securities,
    and Systemic Risks*, 12 [J. Risk & Uncertainty]{.smallcaps} 271,
    277--85 (1996) (arguing that derivatives reduce systemic risk).

[^155]: *See, e.g.,* 11 U.S.C. § 546. These derivatives netting
    provisions apply to all derivatives, whether used for speculation or
    for hedging.

[^156]: *See, e.g.,* Edward R. Morrison & Joerg Riegel, *Financial
    Contracts and the New Bankruptcy Code: Insulating Markets from
    Bankrupt Debtors and Bankruptcy Judges*, 13 [Am. Bankr. Inst. L.
    Rev]{.smallcaps}. 641, 642, 647, 660, & 663 (2005); Enron Corp. v.
    J.P. Morgan Sec., 325 B.R. 671, 684 (Bankr. S.D.N.Y. 2005); Rhett G.
    Campbell, *Financial Markets Contracts and BAPCPA*, 79 [Am.
    Bankr]{.smallcaps}. L.J. 697 *passim* (2005); Christopher J. Redd,
    *Treatment of Securities and Derivatives Transactions in Bankruptcy,
    Part I*, 24-6 ABIJ 36, 37 (2005). \[Explain in text how these
    netting provisions mitigate systemic risk. Cite\]

[^157]: It should be noted in this context that the potential for
    systemic risk from derivatives, absent these bankruptcy netting
    provisions, primarily results from other U.S. bankruptcy law
    provisions that generally impose an automatic stay and invalidate
    ipso facto clauses. \[cite\] Although the insolvency laws of few if
    any foreign countries include netting provisions for derivatives,
    such provisions may be unnecessary to the extent those laws lack
    terms imposing automatic stays or invalidating ipso facto clauses.
    Foreign derivatives contracts, on the other hand, may engender other
    concerns, such as whether such contracts are enforceable or,
    instead, illegal as gambling contracts. Interview with Michael
    Crystal, Q.C., at the International Insolvency Institute's seventh
    annual conference's panel, "Understanding Derivatives: Dissecting
    Complex Financial Instruments," June 12, 2007 (observing that,
    outside the U.S., there are "huge" re-characterization and fraud
    risks in credit derivatives").

[^158]: \[Query also whether derivatives used for hedging are more
    transparent than those used for speculation, and/or are used by
    parties more sophisticated in their use. Cite\]

[^159]: *See* Yamaguchi, *supra* note Error: Reference source not found,
    at 2 (discussing the rise of credit derivatives). *See also* Partnoy
    & Skeel, *supra* note Error: Reference source not found.

[^160]: [Steven L. Schwarcz, Structured Finance, A Guide to the
    Principles of Asset Securitization]{.smallcaps} 12-14 n. 37 (3d ed.,
    supplemented through March 2007).

[^161]: *See* [Schwarcz,]{.smallcaps} *supra* note Error: Reference
    source not found, Chap. 12.

[^162]: *See infra* note Error: Reference source not found.

[^163]: *See infra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text.

[^164]: For example, convergent hedging strategies could concentrate
    rather than diversify risk. *Cf. supra* note Error: Reference source
    not found (noting the danger of convergent investment strategies).
    Hedging strategies are sometimes also unrealistic and, as
    illustrated by LTCM, can fail spectacularly when market liquidity
    dries up. Waldman, *supra* note Error: Reference source not found.
    \[Consider here whether hedging strategies should be fostered
    through regulation, or whether such strategies are best left to the
    market, and whether market-generated hedging strategies should be
    regulated. cite\]

[^165]: Alan Greenspan, Chairman, Board of Governors, U.S. Federal
    Reserve System, Remarks at the Federal Reserve Bank of Chicago's
    Forty-first Annual Conference on Bank Structure: Risk Transfer and
    Financial Stability (May 5, 2005) (transcript available at
    http://www.federalreserve.gov/Boarddocs/Speeches/2005/20050505/default.htm)
    (arguing that hedging can create net protection);
    [Davis,]{.smallcaps} *supra* note Error: Reference source not found,
    at 272 (arguing that although "derivatives have increased linkages
    between market segments, \[causing\] disruption in one \[market\] to
    more readily feed into others," spreading the risk "more widely
    across the financial system \[\] may help to diffuse financial
    instability and prevent systemic risk"). *Cf.* Cifuentes et al.,
    *supra* note Error: Reference source not found, at 24-26 (finding a
    "non-linear response to a shock with respect to a number of \[bank\]
    interlinkages" in that a credit structure diversified among two or
    three banks can trigger, in the case of a bank's default,
    significant systemic contagion to other banks whereas that
    "contagion disappears when the number of linkages is high enough to
    allow banks to stand the losses without selling illiquid assets").

[^166]: *See supra* note Error: Reference source not found and
    accompanying text.

[^167]: *See supra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text.

[^168]: The government report issued after LTCM's near-failure
    recommended a weak variant on this approach: increased disclosure by
    public companies of exposures to highly-leveraged hedge funds. *See
    supra* note Error: Reference source not found and accompanying text.

[^169]: *Cf. supra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text (discussing, in the
    context of the generic example, how contractual counterparties rush
    to try to close out or otherwise protect their positions after a
    large hedge fund or private-equity company defaults).

[^170]: Henry Ordower, *Demystifying Hedge Funds: a Design Primer*, 7
    U.C. [Davis Bus.]{.smallcaps} L.J. 323, 370 (2007). Lending limits
    apply to both individual bank customers and lending between banks.
    *See* Federal Deposit Insurance Corporation Improvement Act of 1991,
    Pub. L. No. 102-242, § 308, 12 U.S.C. § 371 B-2 (1991).

[^171]: *Cf. infra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text (discussing
    diversification of risk through hedging).

[^172]: \[cite1\]

[^173]: *See* John Lipsky, Through the Looking Glass: The Links Between
    Financial Globalization and Systemic Risk, *available at*:
    http://www.imf.org/external/np/speeches/2007/092707.htm.

[^174]: Cover letter included at beginning of [President's Working
    Group,]{.smallcaps} *supra* note Error: Reference source not found
    (observing that "excessive leverage can increase the likelihood of a
    general breakdown in the functioning of financial markets" by
    increasing the likelihood of transmitting problems).

[^175]: [Davis,]{.smallcaps} *supra* note Error: Reference source not
    found, at 40 (concluding that "increased corporate debt in relation
    to equity, assets or cash flow is likely to lead to a greater
    probability of bankruptcy").

[^176]: *Cf.* 11 U.S.C. § 303 (discussing failure to pay debts as the
    basis for involuntary bankruptcy).

[^177]: Reducing leverage also occurs reactively insofar as investors
    experiencing a financial collapse will be more cautious and thus
    incur less leverage in the future. This, however, is a reaction to,
    not a means of mitigating, the collapse, and it does not reduce the
    harm that has been caused. Moreover, those investors may well, over
    time, fall into the pattern of alternating skittishness and optimism
    discussed *infra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text, so that lessons
    about leverage learned from a collapse are eventually disregarded.

[^178]: For example, at least in the U.S., interest paid on debt is tax
    deductible whereas a dividend paid on equity is not. Also, the cost
    of debt is usually lower than the cost of equity because debt is a
    less risky investment than equity. *See* [Davis,]{.smallcaps}
    *supra* note Error: Reference source not found, at 40.

[^179]: According to financing "trade-off" theory, the optimal amount of
    leverage is determined by the amount of tax-breaks and other
    benefits received for debt assumed relative to the costs of that
    debt. James L. Berens & Charles J. Cuny, *The Capital Structure
    Puzzle Revisited*, 8 [Rev. Fin. Stud.]{.smallcaps} 1185, 1185
    (1995). Moderate leverage may prove beneficial, but too much
    leverage will hurt a company and its valuation. *See* Murillo
    Campello, *Debt Financing: Does it Boost or Hurt Firm Performance in
    Product Markets?*, 82 [J. Fin. Econ.]{.smallcaps} 135, 168 (2006).

[^180]: *See supra* notes Error: Reference source not found-Error:
    Reference source not found & Error: Reference source not
    found-Error: Reference source not found and accompanying text.

[^181]: Governor Susan Schmidt Bies, Fed. Reserve Bd., Remarks Before
    the Institute of International Bankers (Sept. 26, 2005).

[^182]: *Cf. supra* note Error: Reference source not found.

[^183]: \[cite1\]

[^184]: *Cf. supra* note Error: Reference source not found.

[^185]: *But cf.* Report and Recommendations Pursuant to Section 401(c)
    of the Sarbanes--Oxley Act of 2002 On Arrangements with Off-Balance
    Sheet Implications, Special Purpose Entities, and Transparency of
    Filings by Issuers (June 15, 2005), *available at*
    <http://www.sec.gov/news/>studies/soxoffbalancerpt.pdf. This SEC
    staff report (the "Report") focused, among other things, on whether
    financial statements of issuers of securities transparently reflect
    the economics of off-balance-sheet arrangements. *Id.* The Report
    recommended that "transactions and transaction structures primarily
    motivated by accounting and reporting concerns, rather than
    economics" be discouraged through a combination of changes to
    accounting standards and greater awareness by participants in the
    financial reporting process. *Id.* at 3. In this latter context, the
    Report suggested that technical compliance with financial reporting
    requirements would be unsatisfactory when investors are nonetheless
    misled or have insufficient information to understand the issuer's
    activities. *Id.* The Report also questioned nuanced approaches to
    accounting disclosure because "financial structures are virtually
    limitless and continue to evolve at a rapid pace." *Id.* at 46.
    Instead, it suggested that "improvement in transparency and
    comparability across issuers can perhaps most directly and quickly
    be accomplished by eliminating the use of such structured
    transactions" whose sole (or perhaps even primary) purpose is
    motivated by accounting treatment. *Id.*

[^186]: *Cf.* Schwarcz, *supra* note Error: Reference source not found,
    at 444-45 (discussing lack of liquidity as the primary cause of
    bankruptcy).

[^187]: *See infra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text. This also responds
    directly to the crux of a systemic collapse since systemic risk is
    \[largely\] a *liquidity* phenomenon: market systemic risk is
    systemic risk that impairs market liquidity, and institutional
    systemic risk is, at least to the extent it involves banks, systemic
    risk that impairs money liquidity.

[^188]: *Cf. supra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text (describing these
    links in the generic example).

[^189]: The "liquidity injection" by the U.S. Federal Reserve, in
    response to the recent sub-prime mortgage crisis, did not actually
    ensure liquidity but merely provided a more attractive borrowing
    environment for banks. *See, e.g.,* Jeremy W. Peters, *The Basics:
    The Banks Roll Up Their Sleeves*, N.Y. [Times]{.smallcaps}, Aug. 19,
    2007, Wk. in Rev., at 2 (observing that when the Federal Reserve
    makes "liquidity injections" into the banking system, "the Fed
    doesn't even use real money," and explaining that liquidity results
    from offering Fed loans to banks at the discount rate, a lower
    interest rate than the "fed funds rate" that banks would charge
    other banks on interbank loans). Moreover, that "liquidity
    injection" affected only banks, not financial markets, directly.
    *See supra* note Error: Reference source not found and accompanying
    text.

[^190]: Bordo et al, *supra* note Error: Reference source not found, at
    19.

[^191]: *Id.*

[^192]: *See id.* at 21.

[^193]: *Cf.* Steven L. Schwarcz, *Sovereign Debt Restructuring: A
    Bankruptcy Reorganization Approach*, 85 [Cornell L.
    Rev]{.smallcaps}. 956, 961-66 (2000) (discussing the moral hazard
    and other costs created when the IMF acts as a lender of last resort
    to financially-troubled nations); Jonathan R. Macey & Maureen
    O'Hara, *Solving the Corporate Governance Problems of Banks: a
    Proposal,* 120 BANKING L.J. 326, 328-29 (Apr. 2003) (discussing
    banks "foist\[ing\] some of their losses onto . . . the federal
    taxpayers whose funds replenish the federal insurance fund when it
    is depleted"); Partnoy, *supra* note Error: Reference source not
    found, at 757-84 (discussing moral hazard in the context of market
    crashes and lenders of last resort).

[^194]: *See* Partnoy, *supra* note Error: Reference source not found,
    at 784 (suggesting this approach); [Davis,]{.smallcaps} *supra* note
    Error: Reference source not found, at 123 ("An essential feature
    \[of a liquidity provider of last resort\] is that its operation
    should be uncertain for any particular institution in difficulties .
    . . .").

[^195]: Tobias Knedlik, *Implementing an International Lender of Last
    Resort* 9--10 (Halle Inst. for Econ. Research, IWH-Discussion Paper
    No. 20, 2006). Qualification criteria could include predictors
    related to the chance of default, such as bank independence and the
    presence of corruption. Repayment incentives may include
    disqualification for future help or "interest rate discounts for
    fast repayments." *Id.* at 10.

[^196]: Gregory Moore, *Solutions to the Moral Hazard Problem Arising
    from the Lender-Of-Last-Resort Facility*, 13 [J. Econ. Surv. 443,
    470 (1999]{.smallcaps}). Another approach to controlling moral
    hazard---shaming those who need to borrow from a liquidity provider
    of last resort, *see id*.---is likely to backfire since society
    wants the borrowing to occur to avoid systemic risk.

[^197]: *See, e.g.,* Arthur E. Wilmarth, Jr., *The Transformation of the
    U.S. Financial Services Industry, 1975-2000: Competition,
    Consolidation, and Increased Risks*, 2002 [U. Ill. L.
    Rev.]{.smallcaps} 215, 228 (2002). Another approach to mitigate
    adverse selection is to require risk-prone participants to pay their
    fair share of the burden. *Cf.* Henri Pagès & David Humphrey,
    *Settlement Finality as a Public Good in Large-Value Payment
    Systems* 5 (Eur. Cent. Bank, Working Paper Series No. 506, 2005),
    *available at* http://www.ecb.int/pub/pdf/scpwps/ecbwp506.pdf
    (discussing how the adverse selection problem is resolved in
    Europe's lender-of-last-resort approach to settlement finality).

[^198]: Kenneth B. Noble, *New Deal Bank Acts Turn 50*, [N.Y.
    Times]{.smallcaps}, June 17, 1983, at D1 ("The F.D.I.C. is financed
    by premiums paid by insured banks. Each bank is assessed one-twelfth
    of 1 percent of its insured deposits. Accounts are insured for up to
    \$100,000 each, although the agency commonly will reimburse
    depositors for more."). \[How might this charging-premium approach
    work, and what might be the premium costs? Cite\]

[^199]: *See, e.g.,* Adam Lerrick, *Funding the IMF: How Much Does it
    Really Cost?*, [Quarterly International Economics
    Report]{.smallcaps}, Nov. 2003, at 1, *available at*
    <http://www.house.gov/jec/imf/11-18-03.pdf> (observing that IMF
    participation is estimated to cost U.S. taxpayers \$1.9 billion
    annually because IMF loans have artificially low interest rates);
    Schwarcz, *supra* note Error: Reference source not found, at 963-64
    (discussing how the IMF raises money from taxpayers of
    member-nations) & at 965-66 (observing that the return to IMF
    member-nations is not only "less than a market rate of interest"
    but, "\[i\]n some cases, . . . even below the member-State's own
    cost of funds").

[^200]: *Cf.* Schwarcz, *supra* note Error: Reference source not found,
    at 965 n. 45 (observing that "\[o\]nly a foolish investor would seek
    a rate of return that is equal to or less than its cost of funds").

[^201]: Privatization might even occur indirectly. *Cf.* Smith,
    Mollenkamp, Perry, & Ip, *supra* note Error: Reference source not
    found, at A8 (observing that, in response to the sub-prime mortgage
    crisis, several large banks in the United States "discussed with the
    Federal Reserve Bank the possibility of borrowing a total of \$75
    billion to be used to buy" mortgage-backed securities, to support
    their value).

[^202]: The global capital markets had approximately \$65 trillion debt
    securities outstanding as of September 30, 2006. Bank for
    International Settlements, [BIS Quarterly Rev]{.smallcaps}. A85-A100
    (Dec. 2006). *See also* Moisés Naím, *Mexico's Larger Story*, 99
    [Foreign Pol'y]{.smallcaps} 112, 122-23 (1995) ("Today, the
    magnitude of the funds controlled by private investment managers
    makes the volumes typically supplied by the IMF and the World Bank
    almost irrelevant.").

[^203]: Schwarcz, *supra* note Error: Reference source not found, at 987
    & 993.

[^204]: *See infra* note Error: Reference source not found and
    accompanying text.

[^205]: *Cf.* Schwarcz, *supra* note Error: Reference source not found,
    at 986 (discussing similar reasons why a priority would be needed in
    a sovereign-debt restructuring context to attract financing).

[^206]: *See* 11 U.S.C. § 364 (authorizing priorities for so-called
    "DIP," or debtor-in-possession, loans).

[^207]: Even the IMF, when acting as a lender of last resort to
    sovereign nations, has priority over the nation's existing
    creditors. Schwarcz, *supra* note Error: Reference source not found,
    at 988.

[^208]: Steven L. Schwarcz, *The Easy Case for the Priority of Secured
    Claims in Bankruptcy*, 47 [Duke L.J.]{.smallcaps} 425, 425 (1997).
    Although that article deals with secured lending priorities, its
    argument applies equally to any set of lending priorities that arise
    merely by operation of law.

[^209]: *See* *id.* at 430.

[^210]: In this context, overinvestment means that a borrower invests
    proceeds of the new money credit in a project that is less valuable
    than the proceeds. If the borrower fails, the prior creditors will
    suffer losses.

[^211]: Schwarcz, *supra* note Error: Reference source not found, at
    989-90.

[^212]: *Cf.* Schwarcz, *supra* note Error: Reference source not found,
    at 990 (suggesting a similar approach for the IMF to disburse
    capital-market funds, as a lender of last resort, to troubled
    nations). As a credit matter, the lenders would be in the same
    position as if they had made the loan directly to the institution.
    *Id.* at 990 & 990 n. 199.

[^213]: *Cf.* [Davis,]{.smallcaps} *supra* note Error: Reference source
    not found, at 268 (suggesting there may be a need for a "market
    maker of last resort" to protect financial markets).

[^214]: *Cf.* Allaudeen Hameed, Wenjin Kang & S. Viswanathan, Stock
    Market Declines and Liquidity 34 (March 28, 2007) (unpublished
    manuscript, on file with author) (finding that market shocks affect
    all prices, with "many asset holders \[being forced\] to liquidate,
    making it difficult to provide liquidity precisely when the market
    demands it").

[^215]: *Cf.* Paul M. Healy & Krishna Palepu, Governance and
    Intermediation Problems in Capital Markets: Evidence from the Fall
    of Enron 26 [(]{.smallcaps}Aug. 15, 2002 draft[,]{.smallcaps}
    available at [www.ssrn.com](http://www.ssrn.com/)) (forthcoming
    \[update cite to\] [J. Econ. Persp.)]{.smallcaps} (fund manager who
    estimates a stock is overvalued but does not act on this analysis
    "and simply follows the crowd" will not be rewarded for foreseeing
    the problems, "but neither will he be blamed for a poor investment
    decision when the stock ultimately crashes, since his peers made the
    same mistake"); Stephen M. Bainbridge, *Mandatory Disclosure: A
    Behavioral Analysis*, 68 [U. Cin. L. Rev.]{.smallcaps} 1023, 1038
    (2000) (discussing how herd behavior may have a reputational payoff
    even if the chosen course of action fails, and arguing that where
    "the action was consistent with approved conventional wisdom, the
    hit to the manager's reputation from an adverse outcome is
    reduced").

[^216]: To the extent these moneys are invested in market-rate
    securities, there should not be losses to taxpayers.

[^217]: *Cf.* Yamaguchi, *supra* note Error: Reference source not found,
    at 3 (arguing in favor of augmenting the functions of central banks
    to act, at least nationally, as lenders of last resort for large
    non-bank institutions and conglomerates). *See also* Vikas Bajaj,
    *Central Banks Intervene to Calm Volatile Markets*, N.Y.
    [Times]{.smallcaps} (Aug. 11, 2007), at 1 (reporting on August 10,
    2007 efforts by the European Central Bank, the U.S. Federal Reserve
    Bank, and other central banks worldwide to coordinate liquidity
    infusions in their respective nations).

[^218]: *See infra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text.

[^219]: \[cite\]

[^220]: \[cite\]

[^221]: \[cite\]

[^222]: *See supra* note Error: Reference source not found and
    accompanying text (observing that the same trigger can foreshadow
    small consequences some times and large consequences other times,
    and that a sorting mechanism may not always be discernible ex ante).

[^223]: *Cf.* [Bookstaber]{.smallcaps}, *supra* note Error: Reference
    source not found, at 157 (arguing that in non-linear systems,
    improvised solutions may work better than set rules).

[^224]: Some institutions, though, may be "too big to fail," and
    therefore incur moral hazard by anticipating a bailout. *See infra*
    note Error: Reference source not found.

[^225]: Marcel Dabos, *Too* *Big to Fail in the Banking Industry: A
    Survey, in* [Too Big to Fail: Policies and Practice in Government
    Bailouts]{.smallcaps} 141 (Benton E. Gup, ed. 2004).

[^226]: *See, e.g.,* Ben S. Bernanke, Chairman, Board of Governors, U.S.
    Federal Reserve System, Remarks at the New York University Law
    School, New York, New York (Apr. 11, 2007) (transcript available at
    <http://www.federalreserve.gov/boardDocs/speeches/2007/20070411/default.htm>)
    (discussing both the mechanisms of market discipline in banking and
    certain forces, such as market participant confidence in bailouts,
    that undermine market discipline).

[^227]: Albert J. Boro, Jr., Comment, *Banking Disclosure Regimes for
    Regulating Speculative Behavior*, 74 [Cal. L. Rev]{.smallcaps}. 431,
    488 (1986) (observing that market discipline can be more efficient
    than top-down regulation). *See also supra* notes Error: Reference
    source not found-Error: Reference source not found (discussing
    direct and indirect costs of regulation).

[^228]: *See, e.g.,* Alfred C. Yen, *Western Frontier or Feudal
    Society?: Metaphors and Perceptions of Cyberspace*, 17 [Berkeley
    Tech. L.J.]{.smallcaps} 1207, 1228 n.73 (2002).

[^229]: *Cf.* Bernanke, *supra* note Error: Reference source not found,
    at 6 (observing that, to the extent hedge funds are regulated solely
    through market discipline, government's "primary task is to guard
    against a return of the weak market discipline that left major
    market participants overly vulnerable to market shocks"). A market
    discipline approach is sometimes used to help solve tragedies of the
    commons. *See supra* note Error: Reference source not found.

[^230]: *Cf.* Bernanke, *supra* note Error: Reference source not found
    (observing that "\[r\]eceivership rules that make clear that
    investors will take losses when a bank becomes insolvent should
    increase the perceived risk of loss and thus also increase market
    discipline" and that, in "the United States, the banking authorities
    have ensured that, in virtually all cases, shareholders bear losses
    when a bank fails").

[^231]: Bernanke, *supra* note Error: Reference source not found; Ryan,
    *supra* note Error: Reference source not found, at 2.

[^232]: *See supra* note Error: Reference source not found and
    accompanying text.

[^233]: *See, e.g.,* Boro, *supra* note Error: Reference source not
    found, at 471; Helen A. Garten, *Banking on the Market: Relying on
    Depositors to Control Bank Risks*, 4 [Yale J. on Reg.]{.smallcaps}
    129, 129--30, 129 n.1 (1986).

[^234]: Bernanke, *supra* note Error: Reference source not found, at 1.
    Professor Romano suggests that the breakdown of market discipline is
    due simply to human greed. *Cf.* Romano, *supra* note Error:
    Reference source not found, at 79 (discussing greed as a central
    factor that, in the hedge-fund context, transforms a successful
    hedging or moderately risky investment strategy into one of
    high-risk speculation). Bernanke suggests, however, a possible
    alternative psychological explanation: that "\[i\]nvestors, perhaps
    awed by the reputations of LTCM's principals, did not ask
    sufficiently tough questions about the risks that were being taken
    to generate the high returns." Bernanke, *supra* note Error:
    Reference source not found, at 1.

[^235]: Partnoy, *supra* note Error: Reference source not found, at 774.

[^236]: *Cf. supra* note Error: Reference source not found.

[^237]: See 11 U.S.C. § 93(b)(2)(A)(ii) (2007) (fining banks for
    recklessly engaging in "unsafe" or "unsound" practices).

[^238]: *See supra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text.

[^239]: Claire A. Hill, *How Investors React to Political Risk*, 8 [Duke
    J. Comp. & Int'l]{.smallcaps} L 283, 287-89 (1998). Scholars
    sometimes distinguish rare and unpredictable risks from other risks
    by calling the former "uncertainty." *Id.* at 287 (citing Frank H.
    Knight, [Risk, Uncertainty, and Profit]{.smallcaps} (1921)).

[^240]: Hill, *supra* note Error: Reference source not found, at 286
    (emphasis in original).

[^241]: *Id.* at 308. *Cf.* note Error: Reference source not found,
    *supra* (discussing the availability heuristic).

[^242]: Hill, *supra* note Error: Reference source not found, at 308.

[^243]: *Cf.* [Davis,]{.smallcaps} *supra* note Error: Reference source
    not found, at 277 (arguing that this pattern may reflect "disaster
    myopia," in which "memories of financial instability can rapidly
    fade, a process intensified by rapid turnover of staff and/or
    intense competition").

[^244]: Greenspan, for example, had a serious bias against regulation
    and assumed market discipline was far better than it actually was.
    [Lowenstein]{.smallcaps}, *supra* note Error: Reference source not
    found, at 231.

[^245]: GAO Report GAO-02-302, SEC Operations: Increased Workload
    Creates Challenges (March 5, 2002) (describing workload exceeding
    available workers since 1995 and also the SEC's small salaries
    compared to other federal agencies which contributes to very high
    turnover), *available at* http://www.gao.gov/new.items/d02302.pdf.
    \[But would that shortage be any less with express regulation?
    Perhaps, because there would be a clearer regulatory enforcement
    mandate to justify hiring, and most people comply with regulations
    anyway. cite\]

[^246]: *See supra* note Error: Reference source not found and
    accompanying text.

[^247]: Congressional Review of Agency Rulemaking Act, Chap 8, USCA &&
    801-08. "Major rules," i.e., rules whose implementation entail
    substantial costs, cannot take effect during the sixty days afforded
    Congress to perform its review. *See* 5 U.S.C. § 801 (a)(3). *Cf.*
    [Eatwell & Taylor,]{.smallcaps} *supra* note Error: Reference source
    not found, at 19 (arguing that a balance needs to be struck when
    examining the benefits and costs of regulation).

[^248]: Draft 2007 Report to Congress on the Costs and Benefits of
    Federal Regulation, Office of Management and Budget, at 8
    (hereinafter, "OMB Report").

[^249]: *Id.* The analysis regarding health and safety regulations is
    often context specific. Compare the EPA's Clean Air Mercury Rule
    where the cost to a state of implementing the cap-and-trade system
    was compared to the ultimate health effects in humans of lowering
    the level of mercury that is consumed (i.e. morbidity, infant
    mortality and such welfare effects as visibility improvements) with
    DOL-OSHA's Regulation on Occupational Exposure to Hexavalent
    Chromium (71 FR 10100) where the benefits of preventing 40-145 fatal
    and 5-20 non-fatal lung cancers per year were weighed against OSHA's
    estimated annual compliance costs of installing engineering controls
    and the purchase and use of supplemental respirators at the new
    Permissible Exposure Limit (\$36-896 million/yr versus \$244-253
    million/yr as monetized by the OMB). Regulatory Impact Analysis of
    the Clean Air Mercury Rule -- Final Report at 1-1 and 12-1; and OMB
    Report, *supra* note Error: Reference source not found, at 60.

[^250]: *Id.* at 8-9. In either event, in assessing costs and benefits,
    regulators often view an industry in isolation and ask what would
    have happened absent the regulation. Robert W. Hahn and John A.
    Hird, *The Costs and Benefits of Regulation: Review and Synthesis,*
    [8 Yale J. on Reg.]{.smallcaps} 233, 239-40 (Winter 1991) (referring
    to this as the "partial equilibrium model"). To the extent
    regulation deals exclusively with economics, agencies will create
    econometric models based on the supply and demand characteristics of
    the industry before and after a regulatory change. *Id.*

[^251]: *See supra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text.

[^252]: This type of regulation is discussed in Cass R. Sunstein,
    *Irreversible and Catastrophic*, [91 Cornell L. Rev. 841,
    848]{.smallcaps} (May 2006). A precautionary principle is most often
    used when assessing the impact of human actions on [complex
    systems](http://en.wikipedia.org/wiki/Complex_system), such as the
    [environment](http://en.wikipedia.org/wiki/Natural_environment) and
    [human health](http://en.wikipedia.org/wiki/Health), where the
    consequences of actions may be unpredictable. [James Salzman &
    Barton H. Thompson, Jr., Environmental Law and Policy]{.smallcaps}
    16 (2nd ed. 2007); Robert G. Chambers & Tigran A. Melkonyan, *Pareto
    Optimal Trade in an Uncertain World: GMOs and the Precautionary
    Principle*, 89 [Am. J. Agric. Econ]{.smallcaps}. 520, 528 (2007).

[^253]: Although this principle is often explicitly mentioned in
    international environmental regulations, it also is implicit in such
    domestic regulation as efforts to prevent terrorist attacks or
    regulation of the nuclear power industry, where high costs are
    justified even in the face of uncertain risk. *See* Cass R.
    Sunstein, *Beyond the Precautionary Principle*, [151 U. Pa. L. Rev.
    1003]{.smallcaps}, 1005-07 (2003).

[^254]: Sunstein, *supra* note Error: Reference source not found, at
    1017-18. Governments have incorporated this principle into
    regulatory policies, and the European Commission has urged that the
    precautionary principle be considered within a structured approach
    to the analysis of risk. *Id.*

[^255]: Under a stronger version of the precautionary principle, when an
    activity is shown to present a significant health or safety risk,
    regulatory decisions should be made so as to prevent the activity
    from being conducted notwithstanding scientific uncertainty as to
    the nature of the damage or the likelihood of its occurrence.
    Sunstein*, supra* note Error: Reference source not found, at 849.
    This stronger version, however, offers little practical guidance to
    regulators. Sunstein *supra* note Error: Reference source not found,
    at 1017-18. *See also* [John D. Graham & Jonathan B. Wiener, Risk
    vs. Risk]{.smallcaps} (1995) (demonstrating that interventions to
    reduce one risk may induce new countervailing risks); Jonathan B.
    Wiener, *Precaution in a Multi-Risk World*, in [Human and Ecological
    Risk Assessment: Theory and Practice]{.smallcaps} 1509 (Dennis D.
    Paustenbach ed., 2002) (arguing that although "precaution" can be a
    desirable strategy in some cases, strong versions of the
    precautionary principle can induce unintended countervailing risks,
    that the goal should be optimal rather than maximal precaution, and
    that actual regulation often moderates the degree of precaution in
    order to avoid these unintended risks).

[^256]: Sunstein *supra* note Error: Reference source not found, at
    1017-18.

[^257]: *See* *supra* note Error: Reference source not found and
    accompanying text (discussing poverty, unemployment, and crime as
    potential social costs).

[^258]: Discounting the consequences of a risk by the probability of its
    occurring is sometimes referred to mathematically as R = p(X), where
    R = Risk, p = probability, and X = severity.

[^259]: For examples of expected value analysis, *see* [Richard A.
    Posner, Economic Analysis of Law]{.smallcaps} § 15.1, at 445 & n.1
    (6^th^ ed. 2003).

[^260]: Memorandum from E. Bruce Leonard, President, International
    Insolvency Institute, to all Institute members 2 (June 16, 2006; on
    file with author) (discussing the prediction of a "25% probability
    within two years of a significant disruption in the international
    financial markets, probably attributable to the collapse or serious
    difficulties of a major hedge fund," as one of the "highlights from
    the Conference").

[^261]: Because the 25% probability of systemic risk absent regulation
    is a two-year estimate, the other values used in these equations
    will be based on two-year estimates. The applicable time period
    chosen is irrelevant so long as it is common for all values since
    these equations are being used solely for comparative purposes.

[^262]: [Lowenstein]{.smallcaps}, *supra* note Error: Reference source
    not found, at [190.]{.smallcaps}

[^263]: \[Update values of *M* from recent sub-prime mortgage crisis.
    Cite1\]

[^264]: The term "biannually" being used here to mean every two years.
    *See supra* note Error: Reference source not found.

[^265]: B[ookstaber,]{.smallcaps} *supra* note Error: Reference source
    not found, at 257 (arguing that regulation will not help if there is
    a failure to understand the mechanisms by which crises develop).

[^266]: \[Explain this claim further. For example, *R* might even
    represent a profit, not a cost, if liquidity is provided to markets
    by purchasing securities at a deep discount. cite1\]

[^267]: *See supra* note Error: Reference source not found and
    accompanying text.

[^268]: *Cf.* Bernanke, *supra* note Error: Reference source not found
    (observing that if hedge funds "were forced to reduce exposures in
    terms of liquidity risk, liquidity in a particular market segment
    could decline sharply and unexpectedly").

[^269]: *See supra* note Error: Reference source not found and
    accompanying text and *infra* note Error: Reference source not found
    and accompanying text.

[^270]: *See* Part III.B.

[^271]: *See supra* Part III.B.

[^272]: This is because *R*, the cost of regulation, being one or more
    orders of magnitude less than *M*, the cost of a systemic meltdown,
    is vanishingly small in comparison and thus, for equation purposes,
    can be effectively treated as zero. Hence *EV~2~* is necessarily
    always less than *EV~1~*.

[^273]: *See supra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text.

[^274]: *See supra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text.

[^275]: *See id.*

[^276]: *Id.*

[^277]: *See supra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text.

[^278]: *See Report and Recommendations Pursuant to Section 401(c) of
    the Sarbanes-Oxley Act of 2002 On Arrangements with Off-Balance
    Sheet Implications, Special Purpose Entities, and Transparency of
    Filings by Issuers* (June 15, 2005), in which the SEC staff
    recommended, *id.* at 3, that "transactions and transaction
    structures primarily motivated by accounting and reporting concerns,
    rather than economics" be discouraged in the future through a
    combination of changes to accounting standards by the Financial
    Accounting Standards Board (FASB) and greater awareness by
    participants in the financial reporting process.

[^279]: The other way is to impose entity-level liquidity requirements.
    *See supra* note Error: Reference source not found and accompanying
    text.

[^280]: *See supra* note Error: Reference source not found and
    accompanying text.

[^281]: *See supra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text.

[^282]: *See supra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text.

[^283]: *See supra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text (cautioning that a
    quantitative analysis is no better than its assumptions, and this
    article's assumptions rely on no hard empirical data; and that a
    truly realistic balancing of costs and benefits could depend on the
    particular mechanisms by which systemic failures can arise).

[^284]: Although the article attempts to be realistic in stressing *M*
    to levels of \$2 billion and \$5 billion, estimates of *M* could
    reach such absurdly-higher levels that just about any regulation
    would be justified. Consider, for example, a systemic-risk doomsday
    scenario along the lines of the Great Depression. From its peak in
    1929, to its cyclical nadir in 1933, the U.S. gross domestic product
    (GDP) shrank 45.6% as a result of that Depression. *GDP and Other
    Major NIPA Series, 1929-2006: II*, [Surv. Current Bus.]{.smallcaps},
    Aug. 2006, at 169, *available at*
    <http://www.bea.gov/scb/pdf/2006/08August/0806_GDP_NIPAs.pdf>. If a
    systemic meltdown of equal consequence hit the United States today,
    the GDP would shrink (using a GDP of \$13.29 trillion, the most
    recent figure available) by---and thus *M* would equal---\$6.06
    trillion. *See id.* at 173. This article does not, however, suggest
    that *M* is likely to be anywhere near that order of magnitude.

[^285]: *EV~1~* = γ × *M* = 25% × \$2,000,000,000 = \$500,000,000.
    *EV~2~* = λ × *M* + *R* = 5% × \$2,000,000,000 + \$1,000,000,000 =
    \$1,100,000,000. Therefore *EV~2~* is greater than *EV~1~*.

[^286]: *EV~1~* = γ × *M* = 25% × \$5,000,000,000 = \$1,250,000,000.
    *EV~2~* = λ × *M* + *R* = 5% × \$5,000,000,000 + \$1,000,000,000 =
    \$1,250,000,000.

[^287]: *See supra* notes Error: Reference source not found & Error:
    Reference source not found and accompanying text.

[^288]: This biannual value for *R* appears reasonable given that the
    much more complex effort of implementing the Basel II regulatory
    measures is estimated by the U.S. Office of Management and Budget to
    cost, in total over four years, only \$545.9 million (present
    value). OMB Report, *supra* note Error: Reference source not found,
    at 56.

[^289]: *EV~1~* = \$500,000,000. *EV~2~* = 0.10 × \$2,000,000,000 +
    \$100,000,000 = \$300,000,000.

[^290]: *EV~1~* = \$1,250,000,000. *EV~2~* = 0.10 × \$5,000,000,000 +
    \$100,000,000 = \$600,000,000.

[^291]: Consider, for example, stressing γ, the likelihood of systemic
    meltdown without regulation, downward from 25% to as low as 10%.
    Then λ, the likelihood of systemic meltdown with regulation,
    necessarily would reduce, say from 10% to 3%. Applying the \$1
    billion, \$2 billion, and \$5 billion variations of *M* yields the
    following results. If *M* = \$1 billion, then *EV~1~* =
    \$100,000,000 and *EV~2~* = \$130,000,000, making regulation
    slightly inefficient. But if *M* = \$2 billion, then *EV~1~* =
    \$200,000,000 and *EV~2~* = \$160,000,000, making regulation
    efficient; and if *M* = \$5 billion, then *EV~1~* = \$500,000,000
    and *EV~2~* = \$250,000,000, making regulation highly efficient.
    \[Also stress γ based on the 10% yearly chance (once every decade)
    of financial crisis discussed at the House Committee on Financial
    Services October 2, 2007 meeting. cite1\]

[^292]: *See supra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text.

[^293]: *See supra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text.

[^294]: *See* Frederic S. Mishkin, *Financial Consolidation: Dangers and
    Opportunities*, 23 [J. Banking & Fin]{.smallcaps}. 675, 683 (1999).
    For this policy to be credible, however, the liquidity provider of
    last resort might sometimes have to let a critical financial
    intermediary fail. Marvin Goodfriend & Jeffrey M. Lacker, *Limited
    Commitment and Central Bank Lending* 19 (Fed. Res. Bank of Richmond,
    Working Paper No. 99-2, 1999).

[^295]: *See supra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text.

[^296]: *See supra* note Error: Reference source not found and
    accompanying text.

[^297]: *See supra* notes Error: Reference source not found-Error:
    Reference source not found & Error: Reference source not
    found-Error: Reference source not found and accompanying text.
    \[Consider also imposing restrictions on loans to minimize adverse
    selection, to avoid deterring systematic risk, and to avoid
    impairing financial innovation. *Cf.* *supra* notes Error: Reference
    source not found-Error: Reference source not found and accompanying
    text (discussing that systematic risk is economically healthy);
    Bernanke, *supra* note Error: Reference source not found, at 6
    (observing that trying to "entirely eliminate systemic risk . . .
    would likely stifle innovation without achieving the intended
    goal"). cite\]

[^298]: *See supra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text. \[Expand textual
    discussion. cite\]

[^299]: Market discipline is a prophylactic regulatory approach and a
    liquidity provider of last resort acts prophylactically to prevent a
    collapse; but the primary function of a liquidity provider of last
    resort is reactive---to mitigate the spread and consequences of
    systemic collapse---and ad hoc approaches are, by definition, purely
    reactive.

[^300]: *See supra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text.

[^301]: *See, e.g.,* Michael Ehrmann & Marcel Fratzscher, *Global
    Financial Transmission of Monetary Policy Shocks* 26--27 (Eur. Cen.
    Bank, Working Paper No. 616, 2006) (showing that U.S. monetary
    shocks have a significant effect on foreign stock markets, and that
    the more financially integrated countries are, the greater the
    effect of a monetary shock in one country on such other countries);
    Michele Fratianni & John Pattison, *International Financial
    Architecture and International Financial Standards*, 579 [Annals Am.
    Acad. Pol. & Soc. Sci.]{.smallcaps} 183, 184 (2002) (observing
    increasing concern over transmission internationally of local
    financial failures).

[^302]: [Rahul Dhumale, John Eatwell, & Kern Alexander, Global
    Governance of Financial Systems: The International Regulation of
    Systemic Risk]{.smallcaps} 20, 82 (2006) (noting that the Bretton
    Woods system received its name from its founding conference in
    Bretton Woods, New Hampshire, in 1944 and comprised several
    agreements among economic planners to rebuild the global economic
    order). These agreements also established the IMF and the
    International Bank for Reconstruction and Development ("World
    Bank"). *Id.*

[^303]: [Eatwell & Taylor,]{.smallcaps} *supra* note Error: Reference
    source not found, at 1. Nations entrusted gold as an international
    medium of exchange because of its earlier use under the gold
    standard, and they accepted the dollar as an international currency
    because the U.S. had accumulated significant quantities of gold.
    [Campbell R. McConnell & Stanley L. Brue, Economics: Principles,
    Problems, and Policies]{.smallcaps} 724 (2004). They therefore came
    to accept gold and the dollar as international reserves, with the
    dollar convertible into gold on demand. *Id.*

[^304]: [Eatwell & Taylor,]{.smallcaps} *supra* note Error: Reference
    source not found, at 1.

[^305]: [Robert Guttman, Money and Finance: Toward a New Monetary
    Regime]{.smallcaps} 15 (1997).

[^306]: [McConnell & Brue]{.smallcaps}, *supra* note Error: Reference
    source not found, at 724. This in turn made it increasingly doubtful
    that the U.S. would be able to continue to convert dollars into gold
    at \$35 dollars per ounce, or that dollars would continue to
    function as instruments of international monetary reserves. *Id.*

[^307]: [Eatwell & Taylor,]{.smallcaps} *supra* note Error: Reference
    source not found, at 1.

[^308]: [Eatwell & Taylor,]{.smallcaps} *supra* note Error: Reference
    source not found, at 1--3. [Dhumale, Eatwell, &
    Alexander,]{.smallcaps} *supra* note Error: Reference source not
    found, at 14.

[^309]: *See, e.g.,* Alan Friedman, *But Nations Appear Reluctant: IMF
    Pushing to Open East Asian Markets,* [Int'l Herald
    Trib.,]{.smallcaps} Sept. 20, 1997 (quoting a top IMF official as
    claiming "the benefits of liberalizing . . . outweigh the potential
    costs" and a former WTO chief as asserting that financial-services
    liberalization was "the cure, not the cause" of East Asian economic
    crisis of 1997); Timothy A. Canova, *The Transformation of U.S.
    Banking and Finance: From Regulated Competition to Free-Market
    Receivership*, [60 Brook. L. Rev]{.smallcaps}. 1295, 1354 n.76
    (noting that in the early 1990's, the U.S. Treasury Department
    unequivocally endorsed financial liberalization by "regularly
    pressuring other nations to free their domestic interest rates and
    divorce central bank policy from democratic and parliamentary
    control").

[^310]: Jayati Ghosh, *The Economic and Social Effects of Financial
    Liberalization: A Primer for Developing countries* 9 (United Nations
    Department of Economic and Social Affairs, Working Paper No. 4,
    2005) *available at*
    http://www.un.org/esa/desa/papers/2005/wp4_2005.pdf ("\[F\]inancial
    liberalization creates exposure to the following kinds of risk: a
    propensity to financial crises, both external and internal; a
    deflationary impact on real economic activity and reduced access to
    funds for small-scale producers, both urban and rural. This in turn
    has major social effects in terms of loss of employment and more
    volatile material conditions for most citizens."); [Gerard Caprio,
    Patrick Honohan, & Joseph E. Stiglitz, Financial Liberalization: How
    Far, How Fast?]{.smallcaps} 15--17 (2001) (observing that the
    liberalized financial markets "laid bare the previous inefficiencies
    and failures in credit allocation" and undermined efforts to valuate
    the true value of bank capital and the true risk of bank
    portfolios). *See also* [Eatwell & Taylor,]{.smallcaps} *supra* note
    Error: Reference source not found, at ix ("The presumption, widely
    held before 1997, that financial liberalization is invariably
    beneficial has now been abandoned by almost all serious
    commentators.").

[^311]: [Dhumale, Eatwell, & Alexander,]{.smallcaps} *supra* note Error:
    Reference source not found, at 14.

[^312]: *Cf.* Elene Spanakos, *Note: Harmonization of International
    Adequacy Rules for Securities Firms: An Argument to Implement the
    Value At Risk Approach by Adopting Basle's Internal Model
    Methodology*, 26 [Brook. J. Int'l L]{.smallcaps}. 221, 241--42, 244
    (2000) (arguing that without international standards there will be a
    "race to the bottom" in regulatory schemes).

[^313]: *See, e.g.,* David T. Llewellyn, *Institutional Structure of
    Financial Regulation and Supervision: The Basic Rules,* p. 7, Paper
    presented at a World Bank Seminar June 6th and 7th, 2006 *available
    at:* info.worldbank.org/etools/library/latestversion.asp?232743
    (arguing that "\[i\]t is an illusion to believe there is a single,
    superior model of institutional structure that is applicable to all
    countries"); [James A. Hanson, Patrick Honohan, & Giovanni Majnoni,
    Globalization and National Financial Systems]{.smallcaps} 273-74
    (2003).

[^314]: Llewewllyn, *supra* note Error: Reference source not found.

[^315]: [Hanson, Honohan & Majnoni]{.smallcaps}, *supra* note Error:
    Reference source not found (arguing that the pervasive looting of
    newly privatized entities in Central and Eastern Europe and the
    subsequent collapse of small country capital markets in places like
    Slovakia evidence the challenges inherent in broad and sudden
    changes to a financial system's regulatory structure). *Accord*,
    [David F. Good, Economic Transformations in East and Central Europe:
    Legacies From the Past and Politics for the Future]{.smallcaps} 3-4
    (1994).

[^316]: *See, e.g.,* James D. Fearon, *Bargaining, Enforcement, and
    International Cooperation*, 52 [International
    Organization]{.smallcaps}, Spring 1998, at 271 ("Whether the goal is
    to control arms racing, reduce the risk of preemptive war, limit
    global environmental damage, stabilize exchange rates, or reduce
    protectionism in trade, state leaders . . . coordinate state
    policies and the actions of the relevant state bureaucracies . . .
    to gain various benefits of cooperating."); [Richard J. Herring &
    Robert E. Litan, Financial Regulation in the Global
    Economy]{.smallcaps} 120--123 (1994) (suggesting systemic risk is
    analogous to epidemiological risk, in that both can be effectively
    resolved by international collaboration when "countries agree\[\] on
    how to act . . . \[and their\] cooperation advance\[s\] to the point
    of establishing an international agency and jointly financing
    international action to control and attempt to eradicate" the
    contagion); Edward J. Kane, *Government Officials as a Source of
    Systemic Risk in International Financial Markets*, *in* [Regulating
    International Financial Markets: Issues and Policies]{.smallcaps}
    257--58 (Franklin R. Edwards & Hugh T. Patrick eds., 1992)
    (analogizing the global financial system to the interconnected
    subsystems of the human body and implying that just as the central
    immune system is the most efficient way to regulate the health of
    the body's many subsystems, so is a universal regulatory approach
    the most efficient means of regulating systemic financial risk).

[^317]: *See* [Davis,]{.smallcaps} *supra* note Error: Reference source
    not found, at 269 (arguing against possible "excessive readiness to
    assume that the current domestic situation is unique"); Benn Steil,
    "Regulatory Foundations for Global Capital Markets," *in* [Finance
    and the International economy, (Richard O'Brien,]{.smallcaps} ed.)
    [66 (1992):]{.smallcaps} "Since any systemic effects of inadequate
    or misguided regulation in one jurisdiction cannot be contained
    within that single jurisdiction, the imposition of universal
    standards or modes or operation is likely to be the only effective
    response." [Dhumale, Eatwell, & Alexander,]{.smallcaps} *supra* note
    Error: Reference source not found, at 270 (proposing the
    establishment of a Global Financial Governance Council to coordinate
    "effective international financial regulation . . . \[using\] a
    multilateral treaty regime that combines legally binding principles
    of efficient regulation (i.e., capital adequacy and consolidated
    supervision) and a mechanism for developing nonbinding soft law
    codes (capital adequacy formulas and coordination of enforcement)"

[^318]: *See* Bank for International Settlements, *Basel II and
    Financial Institution Resiliency*, June 27, 2007, *available at*:
    http://www.bis.org/press/p070627.htm%5D.; [Ioannis S. Akkizidis &
    Vivianne Bouchereau, Guide to Optimal Operational Risk and Basel
    II]{.smallcaps}, 99--105 (2006).

[^319]: \[cite\] The chairman of Basel II concedes, however, that
    implementing the accord will be extremely difficult. Peter Norman,
    *Basel II Chairman Says Rules Will Be Hard to Implement*, [Fin.
    Times]{.smallcaps} (London), Apr. 11, 2005. Some also argue that
    Basel II may actually prove counterproductive. *See, e.g.,*
    [Dhumale, Eatwell, & Alexander,]{.smallcaps} *supra* note Error:
    Reference source not found, at 263 (arguing that because the
    majority of developed nations will adopt some variation of Basel II,
    the G10 countries are likely to exert at least moderate pressure on
    developing nations to permit foreign banks to operate in their
    markets under Basel II, which in turn could have a disproportionate
    impact on the composition of credit risk in those jurisdictions and
    place foreign banks at a distinct advantage over local banks).

[^320]: *See supra* note Error: Reference source not found and
    accompanying text (calling for creation of an ILOLR).

[^321]: *See supra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text.

[^322]: [Robert Keleher,]{.smallcaps} [Joint Economic Committee, An
    International Lender of Last Resort, the IMF, and the Federal
    Reserve 178]{.smallcaps} (Comm. Print 1999) (arguing that the
    Federal Reserve Bank "has international reserve or money-creating
    powers and, accordingly, can act to satisfy increased demands for
    liquidity \[and also\] can act to create liquidity quickly via open
    market operations rather than through the slower, more cumbersome
    discount window mechanism," though tying this argument in part to
    the U.S. dollar being the dominant reserve currency).

[^323]: *Id* at 7 (the IMF "cannot create reserves or international
    money, cannot act quickly enough to serve as an international LOLR,
    and does not operate in a transparent manner. Further, IMF lending
    currently (indirectly) serves to bail out insolvent institutions,
    something wholly inappropriate for an international LOLR.").

[^324]: Knedlik, *supra* note Error: Reference source not found, at 26
    (describing the IMF's substantial access to capital from more than
    20 member states).

[^325]: *Id.* at 8 ("In the case of a global crisis . . . almost
    unlimited reserves would be necessary").

[^326]: *Id.* at 26 (discussing how the IMF could obtain "quantitatively
    unlimited" access to member-state funds).

[^327]: *Systemic Risk Hearing, supra* note Error: Reference source not
    found (statement of the author \[at p. 68 of the Hearing's
    transcript-cite\]).

[^328]: *See supra* note Error: Reference source not found and
    accompanying text. For an interesting attempt to categorize
    mechanisms by which non-systemic market failures can arise, *see*
    Partnoy, *supra* note Error: Reference source not found. *But
    compare* *supra* notes Error: Reference source not found-Error:
    Reference source not found and accompanying text (discussing the
    difficulty of categorizing such mechanisms).

[^329]: *See, e.g.,* B[ookstaber,]{.smallcaps} *supra* note Error:
    Reference source not found, at 255. *See also* Yamaguchi, *supra*
    note Error: Reference source not found, at 3 (observing that even
    the best preventative measures may not succeed in removing the
    sources of systemic risk in an environment where financial
    intermediation evolves at a speed faster than one can anticipate).