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Barney Frank, the thoughtful chairman of the House Financial Services Committee, wants to create a new "systemic risk regulator." This general concept has been endorsed by some extremely distinguished economists. Nevertheless, the Frank proposal is dubious.
Frank and his allies begin with the accurate insight that existing regulation is inadequate. We have a set of overseers who evaluate financial institutions one by one, but "systemic risk" is created by the interactions between institutions. A bank or hedge fund can take what looks like a reasonable bet on its own terms, but it still may blow up if others are making the same bet.
Consider a bank that takes $1 billion of its capital and $4 billion of debt and buys a $5 billion portfolio of Latin American bonds. It figures that even if the bonds go down, they will take at least a month to fall by a fifth, allowing plenty of time to get out before the $1 billion cushion is vaporized. Based on the history of the bond market, this may be a perfectly smart bet. But if a hundred other banks make the same trade, the calculation is thrown off. If something goes wrong, all these banks will run for the exit at once. The market will crash in a day, not a month. Some will get stuck inside the building.
