Toward a clear understanding of the systemic risks of large institutions

ABSTRACT The systemic risk posed by the default of Lehman Brothers and the risks of default in the cases of Bear Stearns and AIG focused government efforts to reform the financial regulatory framework on systemic risk. Yet there remains substantial misunderstanding about the precise nature and source of this systemic risk. For the cases ofAIG and Lehman Brothers, we outline what we consider to be the core areas of systemic risk. In the case of AIG, transactions where the main motivation was to mute the economic impact of regulatory capital rules highlight how any regulatory scheme to reduce risk can lead to negative unintended consequences: in this case a massive concentration of counterparty risk. In the case of Lehman Brothers, unintended consequences of the earlier Bear Stearns bailout created moral hazard as investors expected a similar bailout, leading to unexpected concentrated risk in the money markets. Such events illustrate that even the most well-intended regulations and interventions can lead to negative unintended consequences, lessons critical to formulating the regulatory structure of the future.