Economic impacts

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What Is Systemic Risk?

Systemic risk refers to the risk of collapse of an entire financial system or market, as opposed to the failure of individual entities within it. It is a core concept within financial economics and macroprudential policy. Such a collapse can be triggered by a single event or series of events that create a "domino effect," where the failure of one institution or market segment triggers failures across interconnected components, leading to a broader breakdown. The distinguishing feature of systemic risk is its potential to cause widespread economic damage, affecting the real economy, not just financial participants¹⁵.

History and Origin

While the concept of interconnectedness in financial markets has long been understood, the term "systemic risk" gained significant prominence following the 2007-2008 Financial Crisis. Before this period, there was no single regulatory body explicitly tasked with mitigating systemic risk¹⁴. The crisis highlighted how the failure of a large, interconnected financial institution could rapidly transmit distress throughout the global financial system. A seminal event illustrating this was the bankruptcy of Lehman Brothers in September 2008. The collapse of this major investment bank, which held over $600 billion in assets, sent shockwaves across markets, freezing the interbank lending market and shaking confidence in the government's ability to manage the crisis. This event underscored the need for a framework to identify and contain such risks, leading to significant regulatory reforms globally.

Key Takeaways

• Systemic risk is the potential for a localized failure within the financial system to spread and destabilize the entire system.
• It is distinct from individual firm risk and focuses on the interconnectedness of financial institutions and markets.
• Regulatory responses to systemic risk include enhanced capital requirements, liquidity rules, and the designation of Systemically Important Financial Institutions (SIFIs).
• The goal of systemic risk mitigation is to prevent "too big to fail" scenarios and limit the economic impact of financial distress.
• Identifying and measuring systemic risk remains a complex challenge for regulators and policymakers.

Interpreting Systemic Risk

Interpreting systemic risk involves assessing the likelihood and potential impact of widespread financial disruption. It's not about the failure of a single bank or investment fund in isolation, but rather its capacity to trigger a cascading series of defaults or losses across the system, impacting financial intermediation and credit availability throughout the economy. Regulators evaluate factors such as the interconnectedness of institutions through lending and derivatives, the concentration of risk in certain markets or asset classes, and the potential for common shocks that could affect many firms simultaneously¹², ¹³. High levels of systemic risk suggest a fragile financial system that is vulnerable to severe economic downturns, whereas low levels indicate greater resilience.

Hypothetical Example

Consider a hypothetical scenario where a major, highly interconnected global bank, "GlobalSolve," experiences significant losses due to a sudden downturn in a previously booming sector, such as commercial real estate. If GlobalSolve's losses are so severe that it faces insolvency, its inability to meet its obligations could create a contagion risk. Other banks that have lent money to GlobalSolve or hold its debt securities, or are counterparties to its derivative contracts, would then face losses. This could lead to a loss of confidence in these other institutions, causing depositors to withdraw funds or investors to pull out. The ensuing liquidity squeeze could force these institutions to sell assets quickly, driving down asset prices further and creating a feedback loop of distress across the financial system. This hypothetical scenario illustrates how the failure of one "systemically important" entity can trigger a broader financial crisis, impacting credit markets and the real economy.

Practical Applications

Systemic risk concepts are critical in financial regulation and oversight, influencing policy design and supervisory practices worldwide. One key application is the identification and enhanced supervision of Systemically Important Financial Institutions (SIFIs). These institutions, often labeled "too big to fail," are subjected to stricter regulations, including higher capital requirements and more rigorous stress tests.

The Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted in the United States in 2010, established the Financial Stability Oversight Council (FSOC) with the explicit mandate to monitor risks to U.S. financial stability and promote market discipline¹¹. The FSOC brings together various financial regulators to identify potential emerging threats and make recommendations to address them⁹, ¹⁰. Globally, the Basel III framework, developed by the Basel Committee on Banking Supervision, introduced enhanced capital and liquidity standards for banks with the explicit objective of mitigating systemic risk and improving the resilience of the banking system⁷, ⁸. These regulations aim to prevent excessive leverage and ensure banks have sufficient buffers to absorb losses during times of stress⁶.

Limitations and Criticisms

Despite extensive efforts to regulate and mitigate systemic risk, several limitations and criticisms persist. One major challenge is accurately measuring systemic risk, as there is little agreement among academics and regulators on definitive methods⁵. The dynamic and evolving nature of financial markets means new sources of systemic risk can emerge rapidly, making comprehensive identification difficult⁴. For example, the rapid growth of the shadow banking system and complex derivatives before the 2008 crisis presented novel risks that were not fully understood or regulated.

Critics also argue that some regulatory responses, while well-intentioned, may have unintended consequences or not fully address the underlying issues. For instance, increased capital requirements could potentially lead to higher lending rates and slower economic growth, although this is a subject of ongoing debate³. There are also concerns about the effectiveness of current frameworks in addressing the moral hazard problem, where institutions deemed "too big to fail" may take on excessive risks knowing they might be bailed out in a crisis². Furthermore, the complexity of cross-border financial linkages makes coordinated international risk management challenging, as different jurisdictions may have varying regulatory approaches and priorities¹.

Systemic Risk vs. Idiosyncratic Risk

Systemic risk and idiosyncratic risk are two distinct categories of financial risk. The key difference lies in their scope and impact.

Systemic risk refers to the risk that the failure of one part of the financial system can trigger a cascade of failures across the entire system, leading to a widespread collapse and significant economic disruption. It is non-diversifiable, meaning it cannot be eliminated through portfolio diversification, as it affects the entire market or economy. Examples include a widespread banking crisis, a global liquidity freeze, or the collapse of a major financial market.

Idiosyncratic risk, also known as specific risk or unsystematic risk, is the risk inherent in a specific asset, company, or industry. It arises from factors unique to that particular entity and does not affect the broader market. This type of risk is diversifiable, as it can be reduced or eliminated by holding a well-diversified portfolio of assets across different companies and industries. Examples include a company-specific product recall, a labor strike at a single firm, or a change in management for a particular business.

FAQs

What causes systemic risk?

Systemic risk can be caused by various factors, including excessive leverage within financial institutions, high degrees of interconnectedness among financial firms (e.g., through interbank lending or derivatives contracts), rapid growth of asset bubbles, or common shocks such as a sudden economic downturn or a major policy shift. These factors can create vulnerabilities that allow a localized problem to spread throughout the system.

How is systemic risk regulated?

Systemic risk is regulated through a combination of macroprudential policies and microprudential supervision. This includes establishing higher capital requirements and liquidity risk buffers for banks, conducting regular stress tests to assess resilience to adverse scenarios, and designating certain large, interconnected firms as Systemically Important Financial Institutions (SIFIs) subject to stricter oversight. Regulators also aim to improve data collection and information sharing to better identify emerging risks.

Can systemic risk be eliminated?

Complete elimination of systemic risk is generally considered impractical, if not impossible, given the inherent interconnectedness of modern financial systems. The goal of regulation is not to eliminate all risk, but rather to minimize its probability and potential impact. By building resilience into the financial system and establishing mechanisms for orderly resolution of distressed institutions, policymakers aim to contain systemic events and prevent them from escalating into full-blown financial crises.

What is the "too big to fail" problem in relation to systemic risk?

The "too big to fail" (TBTF) problem refers to the situation where certain financial institutions are so large and interconnected that their failure would pose a catastrophic threat to the entire financial system and the broader economy. This creates an implicit government guarantee, as authorities are often compelled to provide a bailout to prevent widespread collapse, even if it means using taxpayer money. This implicit guarantee can lead to moral hazard, encouraging these institutions to take on excessive risks.