In 2010, Michael Spence asked the question can we regulated systemic risk.  No, but we can prevent systemic risks from reaching a critical mass where they trigger a financial crisis.

The Information Matrix explains why this is true.

Information Matrix

People like a good story.  This is true whether the investment Wall Street is telling them the story about is in the Perfect Information quadrant or in the Blind Betting quadrant.

The key difference between investments in the two quadrants is in the Perfect Information quadrant investors can Trust, but Verify Wall Street’s story.  In the Blind Betting quadrant, opacity (the absence of the necessary information) prevents investors from being able to verify Wall Street’s story.

Whether the story can be verified or not results in a vastly different response when Wall Street’s story is called into doubt.  In the Perfect Information quadrant, the story can be verified and the doubt dismissed.  In the Blind Betting quadrant, the story cannot be verified.  Not only is the doubt not dismissed, but the logical follow-up question arises:  is the investment worth anything?  This too cannot be verified.  Investors recognize this and, as behavioral economics suggests, naturally panic.  The result is a classic bank “run” to get their money back.

Mr. Spence stumbles onto the fact it is hard to tell when Wall Street’s story will be called into doubt.

Systemic risks drive most crises, and pose a challenge for several reasons. First, they are not easy to detect with confidence, and are even more difficult to prove. Second, predicting the exact timing of a break point (when bubbles burst, markets lock up, and credit freezes) is, and will likely remain, beyond our ability. Finally, crises are highly non-linear events, which means that they occur without much warning.

Given this fact set, you wouldn’t expect to be able to regulate systemic risk.  However, by forcing investments into the Perfect Information quadrant, you would expect to be able to limit systemic risk.