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One of the most feared events in banking is the cry of systemic risk. It matches the fear of a cry of fire in a crowded theater or other gatherings. But unlike "fire," the term "systemic risk" is less clearly defined. Moreover, unlike fire fighters, who are rarely accused of sparking or spreading rather than extinguishing fires, bank regulators have at times been accused of, albeit unintentionally, contributing to rather than retarding systemic risk. This paper discusses the alternative definitions and sources of systemic risk, reviews briefly the historical evidence of systemic risk in banking, describes how financial markets have traditionally protected themselves from systemic risk, evaluates the regulations adopted by bank regulators to reduce both the probability of systemic risk and the damage caused by it if and when it may occur, and makes recommendations for efficiently curtailing systemic risk in banking.
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* Loyola University Chicago and Stanford Law School, respectively, Both authors are members of the U.S. Shadow Financial Regulatory Committee. Parts of the first section of the paper are derived from Kaufman 2000 a and b. The paper was presented at a conference following the Third Annual Joint Meeting of the European, Japanese, Latin American, and United States Shadow Financial Regulatory Committees in Amsterdam in June 2001. The authors are indebted to the participants at the conference and to Bill Bergman (Federal Reserve Bank of Chicago) and Edward Kane (Boston College) for helpful comments on earlier drafts.
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