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Tuesday, February 15, 2011

The dynamics of systemic risk in financial markets

Systemic risk can occur anywhere within and without a financial system where that risk can cause negative consequences for an industry, economic sector and financial system.(3) An example of systemic risk is the credit default swaps that were so poorly managed and regulated, they contributed heavily to the financial crisis of 2008-2009.(4) These credit default swaps overestimated the reliability of sub-prime mortgages and the insurance companies that protected investments in large portions of these repackaged mortgages.

Types of systemic risk


Systemic risks can affect the financial solvency of institutions such as banks or it can affect the capacity of an industry to produce at sustainable levels. A systemic risk can also include poor risk management that given certain circumstances would fail to preserve the financial strength of the business(es) that risk management aims to protect. Low cash reserves per aggregate debt risk, or inadequate engineering standards on a large production line are also examples of systemic risk. According to a keynote speech to the Federal Reserve Bank of Atlanta, failure of adequate government regulation is also considered a systemic risk. (3)

Exposure to systemic risk


Exposure to systemic risk is manageable to an extent. Very few risks if any can be prevented from occurring 100 percent of the time. Depending on the industry, regulation of that industry and the management of specific businesses, exposure to systemic risk can vary. For example, in the production of nuclear energy, because systemic risk is so dangerous if not prevented, the exposure to risk is much more heavily regulated than with businesses that have less of an overall impact nationally even if the collapse of those businesses could cause problems for a financial market.

Methods of avoiding systemic risk


Systemic risk can be avoided by regulation of financial transactions that are known to be very risky. Complex financial derivatives or leveraged assets that's value depends on other assets can be a systemic risk if proper risk controls are not in place to avoid excess investment in such products under potentially perilous financial conditions. According to Ben Bernanke, Chairman of the U.S. Federal Reserve Bank indicates the financial help of government plays a role in preventing the greater impact of systemic risk, however he also states, a useful set of laws and actionable practices can prevent the systemic risk from being as threatening to financial markets. (1)

Probability of systemic risk


The probability and potential affect of systemic risk is measured using statistical and economic formulas. The statistical value 'Beta' in addition to correlation data is a measurement that can be used to ascertain systemic risk.(5) If the outcome of these formulas leads to a valid probability of a particular systemic risk being realized, then the possible impact of that risk is measured to assess how to better control against that risk. 'Stress tests' are an example of probability and affect estimation, however, if the tests themselves do not account for enough systemic risk, then the threat of systemic risk on financial markets is underestimated.

Magnitude of systemic risk


How much of a problem systemic risk has on financial markets can vary. Just because a business or industry has systemic risk, doesn't necessarily imply the harm caused by that risk will be worth the cost of prevention.(2) Thus, the cost basis of risk management is an important aspect of financial markets because businesses and/or governments that fail to adequately control systemic risk for the sake of profits, can have an impact on financial markets. This is especially so if they are very large oligopolies linked to other industries. Systemic risk can cause job losses, bankruptcy, industry lackluster and financial ripple affects within businesses and in the economy.(1)

Sources:

1. http://bit.ly/1roDYq (Federal Reserve Bank)
2. http://bit.ly/a6B7sU (NY Fed)
3. http://bit.ly/OaGxg (Taylor)
4. http://bit.ly/bAbrNg (U.S. Government Accountability Office)
5. http://bit.ly/blESQ7 (National Bureau of Economic Research)