Systemic risk
Encyclopedia
In finance
, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries". It refers to the risks imposed by interlinkages and interdependencies in a system or market, where the failure of a single entity or cluster of entities can cause a cascading failure
, which could potentially bankrupt or bring down the entire system or market. It is also sometimes erroneously referred to as "systematic risk
".
which has a cascading effect on other banks which are owed money by the first bank in trouble, causing a cascading failure
. As depositors sense the ripple effects of default, and liquidity concerns cascade through money markets, a panic can spread through a market, with a sudden flight to quality, creating many sellers but few buyers for illiquid assets. These interlinkages and the potential "clustering" of bank run
s are the issues which policy makers consider when addressing the issue of protecting a system against systemic risk. Governments and market monitoring institutions (such as the U.S. Securities and Exchange Commission (SEC), and central banks) often try to put policies and rules in place with the ostensible justification of safeguarding the interests of the market as a whole, claiming that the trading participants in financial markets are entangled in a web of dependencies arising from their interlinkage. In simple English, this means that some companies are viewed as too big and too interconnected to fail. Policy makers frequently claim that they are concerned about protecting the resiliency of the system, rather than any one individual in that system.
Systemic risk should not be confused with market or price risk as the latter is specific to the item being bought or sold and the effects of market risk are isolated to the entities dealing in that specific item. This kind of risk can be mitigated by hedging an investment by entering into a mirror trade.
Consider a portfolio of perfectly hedged investments, we can say that the market risk of this portfolio is nullified. Yet, if there is a downturn in the economy and the market as a whole sinks, the hedges would not be of use. This is the systemic risk to the portfolio.
Insurance is often easy to obtain against "systemic risks" because a party issuing that insurance can pocket the premiums, issue dividends to shareholders, enter insolvency proceedings if a catastrophic event ever takes place, and hide behind limited liability. Such insurance, however, is not effective for the insured entity.
One argument that was used by financial institutions to obtain special advantages in bankruptcy for derivative contracts was a claim that the market is both critical and fragile. However, evidence overwhelmingly suggests that such special treatment, justified by arguments about systemic risk, actually exacerbated systemic risk during the financial crisis and forced the government to bail out derivatives traders.
Systemic risk can also be defined as the likelihood and degree of negative consequences to the larger body. With respect to federal financial regulation, the systemic risk of a financial institution is the likelihood and the degree that the institution's activities will negatively affect the larger economy such that unusual and extreme federal intervention would be required to ameliorate the effects.
" (TBTF) and the "too interconnected to fail" (TICTF) tests. First, the TBTF test is the traditional analysis for assessing the risk of required government intervention. TBTF can be measured in terms of 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. Second, the TICTF test is a measure of the likelihood and amount of medium-term net negative impact to the larger economy of an institution's failure to be able to conduct its ongoing business. The impact is measure beyond the institution's products and activities to include the economic multiplier of all other commercial activities dependent specifically on that institution. The impact is also dependent on how correlated an institution's business is with other systemic risks.
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries". It refers to the risks imposed by interlinkages and interdependencies in a system or market, where the failure of a single entity or cluster of entities can cause a cascading failure
Cascading failure
A cascading failure is a failure in a system of interconnected parts in which the failure of a part can trigger the failure of successive parts.- Cascading failure in power transmission :...
, which could potentially bankrupt or bring down the entire system or market. It is also sometimes erroneously referred to as "systematic risk
Systematic risk
In finance, systematic risk, sometimes called market risk, aggregate risk, or undiversifiable risk, is the risk associated with aggregate market returns....
".
Explanation
Systemic risk has been compared to a bank runBank run
A bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent...
which has a cascading effect on other banks which are owed money by the first bank in trouble, causing a cascading failure
Cascading failure
A cascading failure is a failure in a system of interconnected parts in which the failure of a part can trigger the failure of successive parts.- Cascading failure in power transmission :...
. As depositors sense the ripple effects of default, and liquidity concerns cascade through money markets, a panic can spread through a market, with a sudden flight to quality, creating many sellers but few buyers for illiquid assets. These interlinkages and the potential "clustering" of bank run
Bank run
A bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent...
s are the issues which policy makers consider when addressing the issue of protecting a system against systemic risk. Governments and market monitoring institutions (such as the U.S. Securities and Exchange Commission (SEC), and central banks) often try to put policies and rules in place with the ostensible justification of safeguarding the interests of the market as a whole, claiming that the trading participants in financial markets are entangled in a web of dependencies arising from their interlinkage. In simple English, this means that some companies are viewed as too big and too interconnected to fail. Policy makers frequently claim that they are concerned about protecting the resiliency of the system, rather than any one individual in that system.
Systemic risk should not be confused with market or price risk as the latter is specific to the item being bought or sold and the effects of market risk are isolated to the entities dealing in that specific item. This kind of risk can be mitigated by hedging an investment by entering into a mirror trade.
Consider a portfolio of perfectly hedged investments, we can say that the market risk of this portfolio is nullified. Yet, if there is a downturn in the economy and the market as a whole sinks, the hedges would not be of use. This is the systemic risk to the portfolio.
Insurance is often easy to obtain against "systemic risks" because a party issuing that insurance can pocket the premiums, issue dividends to shareholders, enter insolvency proceedings if a catastrophic event ever takes place, and hide behind limited liability. Such insurance, however, is not effective for the insured entity.
One argument that was used by financial institutions to obtain special advantages in bankruptcy for derivative contracts was a claim that the market is both critical and fragile. However, evidence overwhelmingly suggests that such special treatment, justified by arguments about systemic risk, actually exacerbated systemic risk during the financial crisis and forced the government to bail out derivatives traders.
Systemic risk can also be defined as the likelihood and degree of negative consequences to the larger body. With respect to federal financial regulation, the systemic risk of a financial institution is the likelihood and the degree that the institution's activities will negatively affect the larger economy such that unusual and extreme federal intervention would be required to ameliorate the effects.
Measurement of systemic risk
According to the Property Casualty Insurers Association of America, there are two key assessments for measuring systemic risk, the "too big to failToo Big to Fail policy
"Too big to fail" is a colloquial term in regulation and public policy that refers to businesses dealing with market complications related to moral hazard, macroeconomics, economic specialization, and monetary theory....
" (TBTF) and the "too interconnected to fail" (TICTF) tests. First, the TBTF test is the traditional analysis for assessing the risk of required government intervention. TBTF can be measured in terms of 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. Second, the TICTF test is a measure of the likelihood and amount of medium-term net negative impact to the larger economy of an institution's failure to be able to conduct its ongoing business. The impact is measure beyond the institution's products and activities to include the economic multiplier of all other commercial activities dependent specifically on that institution. The impact is also dependent on how correlated an institution's business is with other systemic risks.