Using ‘Cap and Trade’ to Contain Systemic Financial Risk

Systemic risk depends upon aggregate exposure for the entire financial sector, as well as the pattern of exposures between firms. There is a parallel with global warming, where the rise in the Earth’s temperature depends upon the aggregate volume of CO2 and other greenhouse gases in the atmosphere. This suggests that ‘cap and trade,’ issuing licenses that limit aggregate financial sector ratios but allowing firms to trade licenses with each other so that their individual contributions can vary, is a useful approach to containing systemic financial risk. In particular it avoids potentially costly direct control of individual firm liabilities. Cap and trade does not appear difficult to implement for controlling aggregate maturity mismatch, and unlike many other regulations can be introduced on a jurisdiction by jurisdiction basis, without being undermined by cross-border arbitrage or by the movement of risk into the unregulated sector. The main requirement is a comprehensive liability register, which will in any case be very useful to regulators both for risk monitoring and for resolution of failed institutions. Industry will object that this requires a major change in their business models, but this could reduce financial market volatility and hence provide further benefits to investors.