Systematic Risk

“We simply cannot accept a system in which hedge funds and private equity firms insider banks can place huge risky bets that are subsidized by taxpayers,’’ Obama said at the news conference this week announcing his proposal.

Bank of America-Merrill Lynch, the private-equity firm of the nation's largest commercial bank, owns 25% of the health care company, HCA.


Merrill made the investment when HCA was taken private in a $33 billion leveraged buy out in 2006. Since then, HCA has reduced its debt load, boosted revenue and, as Deal Journal wrote about earlier, is paying a fat $1.75 billion cash fourth quarter dividend to its investors.

White House officials have said the Volcker rule would likely allow commercial banks to make investments on behalf of clients, but not with the bank’s own money. Whether a Volcker rule would affect BofA’s HCA investment remains unclear.

Obama said in his State of the Union address that he would veto any reform legislation that fails to reduce systematic risk.

Systematic risk is essentially the correlation of losses of market participants. There are two main ways to measure systemic risk: Too big To fail (TBTF) and Too interconnected to fail (TICTF).

TBTF compares an institution's size relative to

the national and international marketplace, market share concentration, and competitive barriers to entry or how easily a product can be substituted.

The national insurance marketplace, for example, simply requires capital input to become a player and therefore one homeowner's insurance policy can easily be replaced by another.

a state residual market provider, with limits on the underwriting fluidity primarily stemming from state-by-state regulatory impediments, such as limits on pricing and capital mobility. There are arguably either no or extremely few insurers that are TBTF in the U.S. marketplace.

TICTF, on the other hand, measures the impact and likelihood medium-term impact of the larger economy if the institution were to fail.

The impact is measured not just on the institution's products and activities, but also the economic multiplier of all other commercial activities dependent specifically on that institution. It is also dependent on how correlated an institution's business is with other systemic risk.

Regulation, such as the bank regulation that Obama is proposing, cannot be the means to an end of systematic risk. Other sectors, such as insurance companies & private equity, would be in a position to take over the former risks of banks and the systematic risk would be maintained.