You can’t control what you don’t understand. Just take a look at the financial sector.

Despite the trauma of the 2008 financial crisis, the opacity of the financial sector and the oblique way decisions about financial risk are handled by institutions have remained central problems for the global economy. With this in mind, INET Grantee Edward Kane offers some new thinking on how to measure systemic risk in the financial sector. 

In a paper Kane authored with Armen Hovakimian and Luc Laeven as part of their INET-funded research, the researchers offer “a theoretically sound and easy-to-implement way to measure the systemic risk of financial institutions using publicly available accounting and stock market data.” The paper, titled “Variation in Systemic Risk at US Banks During 1974-2010,” acknowledges that financial risk isn’t just a matter of individual institutions. Instead, it derives from a complex web of financial behavior.

“The existence of a safety net incentivizes banks to raise their risk profiles, under-reserve for loss exposures, and to conceal actual losses,” they write. “Unless policymakers vigilantly and conscientiously address this incentive problem and the regulatory arbitrage it produces, aggressive firms will be tempted to abuse the financial safety net in clever ways.”

To limit this financial freeriding, regulators, government officials, and the public need to be able to make transparently determined measurements of financial risk. This paper provides some new economic thinking to fill that void.

Kane, Hovakimian, and Laeven then apply their model to quarterly financial data over the last 30 years.  The results pass the smell test, indicating that systemic risk reached “unprecedented highs” during the heart of the financial crisis from 2008 to 2010.

To read the full paper, download the attachment below.

You can also watch an interview with Edward Kane that was part of INET”s “30 Ways to Be an Economist” interview series that features innovative and noteworthy new economic thinkers.