Systemic risk can be a tricky term to define, but it’s one that is getting much attention following the recent shake-ups in our economy, St. Louis Fed President Jim Bullard said Oct. 2 in a speech to faculty members and graduate students in economics at Indiana University—Bloomington.
“Systemic risk is often associated with incomplete information,” Bullard said. “In the case of a banking system, systemic risk can arise when a bank’s depositors—even relatively sophisticated depositors, such as other banks—become unsure about the condition of the bank in which they hold their funds.” (Read the full text or watch a video of the speech. Bullard’s remarks start about 11 minutes into the clip.)
Greater supervision of financial firms, Federal Reserve oversight of the payments and settlement system, and creation of an orderly framework to liquidate investment banks and other securities firms might decrease systemic risk, Bullard said. No firm, though, should be considered too big or too connected to fail because of systemic concerns, he said.
“Bailouts are expensive—not just because they commit taxpayer funds, but because they can encourage behavior that increases subsequent systemic risk,” Bullard said. “A firm that expects government protection if its investments go awry may take bigger gambles than a firm that expects no protection.”
For more from Bullard, see his speeches and “Worry Less about Systemic Risk, More about Inflation” in the October 2008 Regional Economist.