Congress debated a very important subject this past week: how to regulate the financial industry in order to reduce what is called “systemic risk.” Although the debate was overshadowed by the flap over bonus payments at AIG, the insurance industry is playing an important behind-the-scenes role.

Senators Dodd and Shelby (respectively the Chairman and ranking minority member of the Finance Committee) are involved in the debate, but the key individual is Chairman Barney Frank of the House Financial Services Committee. Questions have been raised about the degree to which Dodd is even interested in the debate, and, as a Republican, Shelby hasn’t much of a voice anyway.

But Frank is engaged, highly knowledgeable, and determined to aggressively re-regulate the financial sector. The problem with Frank is that, as he disclosed in vivid public statements last week, he doesn’t trust private enterprise to get things right.

The insurance industry badly wants to escape new curbs on its activities from the ineluctable wave of new regulations Frank will lead. Insurance companies are regulated by the states rather than by the federal government. They don’t take deposits from the public so they escape the purview of the FDIC.

But the emergency bailout of AIG last September was engineered by the Federal Reserve, which is perhaps the only entity on earth that could conjure up an $85 billion credit line on a single day’s notice. Thus the question for Frank is which federal agency should be given the task of regulating systemic risk: the Fed? The SEC? The FDIC? All of the above? Some totally new, as yet uncreated agency?

Insurance-industry lobbyists have been making the case to Frank that he should find a way to manage systemic risk before he goes about regulating individual sectors of the financial industry. They want him to find a way to prevent coordinated collapses across many markets before he starts rewriting the rules for their industry.

But the lobbyists rolled snake-eyes this week, with the vicious flap over AIG. It’s perfectly clear insurance companies that participate heavily in the shadow banking system, contribute to systemic risk.

Many suppose we need to prevent financial companies from getting too big (and by extension, to prevent their employees from making unseemly amounts of money). If no one is allowed to become Too Big, then no one can become Too Big To Fail, and thus no future bailouts will be required.

But this ignores that systemic risk can arise when nearly every financial actor (large or small) makes a similar bet, in this case that mortgage-backed securities purchased with borrowed money would not collapse in value. There simply isn’t enough capital in the world to reserve against such a “meta-systemic” configuration of risk, especially when market liquidity disappears, as it reliably does in times of crisis.

To Barney Frank, the problem is designating a regulator for systemic risk so that he can get on with whatever will come next. But after he does so and declares the systemic-risk problem to be definitively solved, we’ll still be left with no one knowing what the next source of systemic risk will be.

Investors aren’t in business to lose money. They already know enough to avoid the specific errors that led to this crisis. But systemic risk is a built-in feature of highly-liquid financial markets, and it doesn’t disappear just because Congress says so. Naming a regulator simply papers over the fact that no one knows how to mitigate systemic risk, short of outlawing financial innovation altogether.

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