Why Systemic Risk Oversight Matters

Jorge A Chan-Lau

Since the Great Depression of 1929, the financial system has experienced several severe crises: the debt crisis in Latin America in the 1980s, the collapse of the European exchange rate mechanism and the Scandinavian banking crisis of the early 1990s, the 1997 Asian crisis and the Russian financial crisis in 1998, which prompted the collapse of Long Term Capital Management (LTCM), a highly leveraged hedge fund.

However, none of these events brought the world economy closer to a second great depression than the global financial crisis of 2008. Although the crisis was touched off by problems in the subprime mortgage market in the US, the interconnectedness between financial institutions and the shadow banking system, and frictions arising from the regulatory and institutional framework, contributed to what is now referred to as the Great Recession. Notwithstanding massive government stimulus packages, the world economy contracted by 2.3% in real terms in 2009, the first time in more than a decade that it posted negative growth.

One of the key lessons from the Great Recession is that measuring and assessing the risks of financial institutions in isolation is misleading. A stand