A new idea for keeping systemic risk in check

As the regulatory restructuring debate heats up, two financial consultants are proposing a plan for defining and controlling systemic risk that serves as yet another example of how to make use of laws, rather than agencies, to temper the growth of large financial institutions.

JJ Hornblass and Boaz Salik have proposed creating an anti-trust-style law to mandate the breakup of companies that grow too big to fail. They´ve also come up with what seems like a fairly objective test for determining how big is too big.

"There´s a certain point at which the sheer volume of assets being sold into a market precludes liquidation in a normative manner," reads the white paper Hornblass and Salik have posted on the Internet. They suggest using the notion of "disorderly liquidation" to identify too-big-to-fail institutions. Any firm that has so many assets that selling them quickly would devalue similar instruments held by other companies would meet the qualification.

Of course, the too-big-to-fail test isn´t entirely simple. The paper points out that, "The mark-to-market accounting required by public companies amplifies the risks associated with liquidation.

"As market prices for an asset climb, mark-to-market accounting lets an investor in that asset recognize greater paper profits. However, such profits may quickly disappear, or even turn into huge losses, when the owner tries to liquidate the assets. Unfortunately, this change in fortune may not happen for months or even years, depending on when management decides to liquidate (a serious moral hazard in itself). Or, as in AIG´s case, it could happen at the worst possible time, when other investors decide to liquidate their own holdings."

More controls become necessary. The consultants suggest limiting firms´ holdings of assets in a given class once they exceed the average daily trading volume by a certain amount.

It´s easy to imagine the plan being effective, even though it does not make any mention of a group of people designated to oversee systemic risk. A beefed-up Securities and Exchange Commission could keep track of asset holdings, and perhaps a new branch of the SEC could be created to resolve institutions that grow too large.

But we must also wonder what, if such a plan were implemented, innovative traders and Wall Street executives looking to circumvent the new limitations would think of next.