The near-complete collapse of financial systems worldwide has
exposed fundamental weaknesses in their architecture and in how they
are regulated. In calling for measures to “guard against systemic
risk,” the G-20 summit has begun the process of reconstruction by
recognizing that the system in its entirety, not just individual
institutions, must be regulated.

Unfortunately, the G-20 communiqué offers only more of the same
prescriptions for managing systemic risk that the Financial Stability
Forum (FSF), the United States Federal Reserve, and others have put
forward. These proposals have focused on the problems caused by poor
transparency, over-leveraging, outsized financial institutions, tax
havens, bad incentives for financial bosses, and credit rating
agencies’ conflicts of interest. All of these are important, but they
miss a fundamental point.

No one now denies that the past year’s sharp downswings in housing
and equity prices, which followed long upswings – far above historical
benchmark levels – helped to trigger and fuel the crisis. As these
downswings continue, there is a danger that they, too, may become
excessive, dragging the financial system and the economy even deeper
into crisis.

Containing systemic risks, therefore, requires not just ensuring
transparency and managing leverage in the system, but also recognizing
that these risks vary along with asset values.  If institutions that
were heavily exposed had understood this, they would have raised their
capital buffers during the run-up in housing and equity prices in order
to protect themselves against the inevitable reversals. But, as we now
know, they did not.

One reason for this failure is that pillar 1 of the Basel II
Agreement, which outlines how banks around the world should assess
credit risks and determine the size of capital buffers, makes no
explicit allowance for long-swing fluctuations in asset markets.
Instead, it relies on value-at-risk (VaR) measures that link risk to
standard notions of short-term market volatility.

The problem here is that these measures implicitly assume that risk
declines when markets are doing well: they demand less capital during
calm periods and more capital during volatile periods. In effect, the
presumption is that capital losses are random, so the sharp reversals
and losses that usually ensue after excessive upswings in prices are
disregarded in risk calculations.

Indeed, because standard measures of the probability of default fall
when the economy is doing well and rise when it is not, capital
requirements based on these measures tend to be pro-cyclical. But this
systemic risk, rather than reducing it.

The G-20 has now called for revising the Basel II standards so that
capital requirements become countercyclical, and Spain’s experience
with such requirements suggests that doing so is a step in the right
direction. But such revisions of Basel II are not enough, because bank
portfolios – especially those of international banks with large trading
books – are vulnerable to the risks stemming from long-swing
fluctuations in asset markets.

As a result, not only are countercyclical measures needed, but
banks’ capital requirements should vary inversely with the
boom-and-bust fluctuations in the asset markets to which they are
heavily exposed. Banks’ defenses need to be fortified during excessive
upswings in asset prices so that they are able to weather the
inevitable reversals.

The connection between financial risk and asset-price swings emerges
from the use of a new approach – Imperfect Knowledge Economics (IKE) –
to understanding risk and fluctuations in asset markets. This approach
implies that more can be done to reduce systemic risk, beyond reforming
how risk is measured and capital buffers determined.

IKE acknowledges that, within a reasonable range, the market does a
far better (though not perfect) job in setting prices than regulators
can. But it also recognizes that price swings can become excessive, in
the sense that participants may bid asset prices far from levels that
are consistent with their long-term values.

History teaches that such swings are not sustainable, and that the
more excessive they become, the sharper and more costly are the
eventual reversals – and the graver the consequences for the financial
system and the economy. The lesson of this crisis is that excessive
swings need to be dampened with a set of prudential measures.

One possible measure is to announce “guidance ranges” for asset
prices, with targeted variations of margin and capital requirements,
not to eliminate, but to help damp down movements outside these ranges.
The key feature of these measures is that they are applied differently
depending on whether an asset is over- or undervalued relative to the
guidance range. Their aim is to discourage trading that pushes prices
further away from the range and to encourage trading that helps to
bring them back.

Improving the ability of financial markets to self-correct to
sustainable values is the entire point of prudential regulation. By
contrast, wholesale restrictions on short-selling (and other such
measures that pay no regard to whether an asset is over- or
undervalued) – an option that some have suggested – could actually lead
to greater instability. Rules that are beneficial in some circumstances
may become counterproductive in others. So the idea that what the world
needs now is more fixed rules will not do.

Unfortunately, contemporary economic theory, with its presumption of
perfect price discovery in asset markets, has discouraged economists
and policymakers from paying any attention to the role of asset-price
swings in managing systemic risk. Today’s global crisis shows that we
can no longer afford to ignore this vital factor.

Roman Frydman,
Professor of Economics at New York University, and Michael D. Goldberg,
Professor of Economics at the University of New Hampshire, are the
authors of
Imperfect Knowledge Economics: Exchange Rates and Risk.