Sometimes resources are badly employed because of coordination failures. Actions by decision makers that affect the likelihood of such failures are sometimes said to cause “systemic risk.” This paper seeks to consider the externality in the choice of ex ante risk management policies by individuals and firms, concerned with private risk, not with their contribution to systemic risk.
The implications for debates over fair value accounting are considered.
One consequence is that individuals and firms become overleveraged from a social viewpoint. The recent credit crisis exemplifies the importance of this problem. The US tax system taxes equity more heavily than debt, and therefore exacerbates the bias toward overleveraging. A possible solution is to reduce or eliminate taxation of corporate income and capital gains. Preparedness externalities can also cause firms to become too transparent, and thereby subject to financial runs.
The paper offers insights into systemic risk, coordination failures, and preparedness externalities, focusing on tax and accounting policy.
