Systemic risk

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.^[1] It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries".^[2] 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.^[3] It is also sometimes erroneously referred to as "systematic risk".

Explanation

The easiest way to understand systemic risk is to consider a bank run 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, creating many sellers but few buyers. These interlinkages and the potential "clustering" of bank runs are the issues which policy makers consider when addressing the issue of protecting a system against systemic risk.^[1][4] Governments and market monitoring institutions (such as the SEC, and central banks) often try to put policies and rules in place to safeguard the interests of the market as a whole, as all the trading participants in financial markets are entangled in a web of dependencies arising from their interlinkages and often policy makers are concerned to protect the resiliency of the system, rather than any one individual in that system.^[4] Sometimes "picking winners" and protecting favored individual participants in a system can engender moral hazard in a system and weaken the resilience of the system as a whole.^[5]

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 difficult to obtain against "systemic risks" because of the inability of any counterparty to accept the risk or mitigate against it, because, by definition, there is likely to be no (or very few) solvent counterparties in the event of a systemic crisis. For example it is difficult to obtain insurance for life or property in the event of nuclear war. The essence of systemic risk is therefore the correlation of losses. Because of the interdependencies between market participants, an event triggering systemic risk is much more difficult to evaluate than "specific risk". For example, while econometric estimates and expectation proxies in business cycle research led to a considerable improvement in forecasting recessions, good analysis on "systemic risk" protection is often hard to obtain, since interdependencies and counterparty risk in financial markets play a crucial role in times of systemic stress, and the interaction between interdependent market players is extremely difficult (or impossible) to model accurately. If one bank goes bankrupt and sells all its assets, the drop in asset prices may induce liquidity problems of other banks, leading to a general banking panic.^[1][4]

One concern is the potential fragility of liquidity in some highly leveraged financial markets.^[1][4] If the participants are trading at levels far above their capital bases, then the failure of one participant to settle trades may deprive others of liquidity, and through a domino effect expose the whole market to systemic risk.^[6]

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.^[7]

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 fail" (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. ^[8]

Too Big To Fail: The traditional analysis for assessing the risk of required government intervention is the "Too Big to Fail" Test (TBTF). TBTF can be measured in terms of an institution's size relative to the national and international marketplace, market share concentration (using the Herfindahl-Hirschman Index for example), and competitive barriers to entry or how easily a product can be substituted. While there are large companies in most financial marketplace segments, the national insurance marketplace is spread among thousands of companies, and the barriers to entry in a business where capital is the primary input are relatively minor. The policies of one homeowners insurer can be relatively easily substituted for another or picked up by a state residual market provider, with limits on the underwriting fluidity primarily stemming from state-by-state regulatory impediments, such as limits on pricing and capital mobility. There are arguably either no or extremely few insurers that are TBTF in the U.S. marketplace.

Too Interconnected to Fail: A more useful systemic risk measure than a traditional TBTF test is a "Too Interconnected to Fail" (TICTF) assessment. An intuitive TICTF analysis has been at the heart of most recent federal financial emergency relief decisions. TICTF 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 measured not just on the institution's products and activities, but also the economic multiplier of all other commercial activities dependent specifically on that institution. It is also dependent on how correlated an institution's business is with other systemic risk.^[9]

Factors

Factors that are found to support systemic risks^[10] are:

1. Economic implications of models are not well understood. Though each individual model may be made accurate, the facts that (1) all models across the board use the same theoretical basis, and (2) the relationship between financial markets and the economy is not known lead to aggravation of systemic risks.
2. Liquidity risks are not accounted for in pricing models used in trading on the financial markets. Since all models are not geared towards this scenario, all participants in an illiquid market using such models will face systemic risks.

Diversification

Risks can be reduced in four main ways: Avoidance, Reduction, Retention and Transfer. Systemic risk is a risk of security that cannot be reduced through diversification. Also sometimes called market risk or un-diversifiable risk. Participants in the market, like hedge funds, can themselves be the source of an increase in systemic risk^[11] and transfer of risk to them may, paradoxically, increase the exposure to systemic risk.

Regulation

One of the main reasons for regulation in the marketplace is to reduce systemic risk.^[4] However, regulation arbitrage - the transfer of commerce from a regulated sector to a less regulated or unregulated sector - brings markets a full circle and restores systemic risk. For example, the banking sector was brought under regulations in order to reduce systemic risks. Since the banks themselves could not give credit where the risk (and therefore returns) were high, it was primarily the insurance sector which took over such deals. Thus the systemic risk migrated from one sector to another and proves that regulation cannot be the sole protection against systemic risks.^[12]

Project risks

In the fields of project management and cost engineering, systemic risks include those risks that are not unique to a particular project and are not readily manageable by a project team at a given point in time. These risks may be driven by the nature of a company's project system (e.g., funding projects before the scope is defined), capabilities, or culture. They may also be driven by the level of technology in a project or the complexity of a project's scope or execution strategy.^[13]

Systemic risk and insurance

Property casualty insurance companies, other than in a few specialized segments, present relatively low systemic risk. They cause relatively little counterparty risk and their liabilities are generally independent of economic cycles or other potential systemic failures. Regarding liabilities, property casualty products tend to be mandatory with inelastic demand, thus revenues are less affected by other systemic risks. Recessions or 3rd party failures do not significantly increase workers' injuries, auto accidents or house fires. Insurance contracts are not typically subject to further hedging or risk arbitrage, unlike mortgage underwriting or financial guarantees. Regarding assets, property casualty insurers don't hold other people's money, so there wouldn't be a run on the bank and they only underwrite based on their own assets.^[14]

As an example, a large auto insurance writer would pose very little systemic risk to the larger economy, regardless of its size. Policyholders would be largely protected by existing state guaranty funds and new business could be switched relatively easily to other providers or a state residual market provider. The insurer's contracts with its agents and other suppliers would move quickly to new underwriters, and the beneficiaries of its investments would also similarly move over a short perior of time. Also, the frequency of claims is not subject to the market. If the stock market fluctuates, there would not necessarily be a correlating rise or fall in the amount of auto accidents.^[15]

Discussion

Systemic risk evaluates the likelihood and degree of negative consequences to the larger body. The term "systemic risk" is frequently used in recent discussions related to the economic crisis, such as the Subprime mortgage crisis. 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. The failing of financial firms in 2008 caused systemic risk to the larger economy. Chairman Barney Frank has expressed concerns regarding the vulnerability of highly-leveraged financial systems to systemic risk and is considering how to address financial services regulatory reform and is focusing on the issue of systemic risk.^[16][17]

References

See also

• Bank run
• Financial crisis
• Modern portfolio theory
• Risk modeling
• Taleb Distribution