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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][2] It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries".[3] 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.[4] It is also sometimes erroneously referred to as "systematic risk".

ExplanationEdit

Systemic risk has been compared to 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, with a sudden flight to quality, creating many sellers but few buyers for illiquid assets. 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][5] 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.[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.

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.[1][5][6][7]

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.[8]

A general definition of Systemic Risk which is not limited by its mathematical approaches, model assumptions or focus on one institution; and which is also the first operationalizable definition of Systemic Risk encompassing the systemic character of financial, political, environmental, and many other risks is available since 2010.[9]

Measurement of systemic riskEdit

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.[10]

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.[11]

FactorsEdit

Factors that are found to support systemic risks[12] 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.

DiversificationEdit

Risks can be reduced in four main ways: Avoidance, Diversification, Hedging and Insurance by transferring risk. Systemic risk, also called market risk or un-diversifiable risk, is a risk of security that cannot be reduced through diversification. Participants in the market, like hedge funds, can be the source of an increase in systemic risk[13] and transfer of risk to them may, paradoxically, increase the exposure to systemic risk.

Until recently, many theoretical models of finance pointed towards the stabilizing effects of diversified (i.e., dense) financial system. Nevertheless, some recent work has started to challenge this view, investigating conditions under which diversification may have ambiguous effects on systemic risk.[14][15] Within a certain range, financial interconnections serve as shock-absorber (i.e., connectivity engenders robustness and risk-sharing prevails). But beyond the tipping point, interconnections might serve as shock-amplifier (i.e., connectivity engenders fragility and risk-spreading prevails).

RegulationEdit

One of the main reasons for regulation in the marketplace is to reduce systemic risk.[5] 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 of only one industry cannot be the sole protection against systemic risks.[16]

Project risksEdit

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.[17]

Systemic risk and insurance Edit

In February 2010, international insurance economics think tank, The Geneva Association, published a 110-page analysis of the role of insurers in systemic risk.[18]

In the report, the differing roles of insurers and banks in the global financial system and their impact on the crisis are examined (See also CEA report, "Why Insurers Differ from Banks").[19] A key conclusion of the analysis is that the core activities of insurers and reinsurers do not pose systemic risks due to the specific features of the industry:

  • Insurance is funded by up-front premia, giving insurers strong operating cash-flow without the requirement for wholesale funding;
  • Insurance policies are generally long-term, with controlled outflows, enabling insurers to act as stabilisers to the financial system;
  • During the hard test of the financial crisis, insurers maintained relatively steady capacity, business volumes and prices.

Applying the most commonly cited definition of systemic risk, that of the Financial Stability Board (FSB), to the core activities of insurers and reinsurers, the report concludes that none are systemically relevant for at least one of the following reasons:

  • Their limited size means that there would not be disruptive effects on financial markets;
  • An insurance insolvency develops slowly and can often be absorbed by, for example, capital raising, or, in a worst case, an orderly wind down;
  • The features of the interrelationships of insurance activities mean that contagion risk would be limited.

The report underlines that supervisors and policymakers should focus on activities rather than financial institutions when introducing new regulation and that upcoming insurance regulatory regimes, such as Solvency II in the European Union, already adequately address insurance activities.

However, during the financial crisis, a small number of quasi-banking activities conducted by insurers either caused failure or triggered significant difficulties. The report therefore identifies two activities which, when conducted on a widespread scale without proper risk control frameworks, have the potential for systemic relevance.

  • Derivatives trading on non-insurance balance sheets;
  • Mis-management of short-term funding from commercial paper or securities lending.

The industry has put forward five recommendations to address these particular activities and strengthen financial stability:

  • The implementation of a comprehensive, integrated and principle-based supervision framework for insurance groups, in order to capture, among other things, any non-insurance activities such as excessive derivative activities.
  • Strengthening liquidity risk management, particularly to address potential mis-management issues related to short-term funding.
  • Enhancement of the regulation of financial guarantee insurance, which has a very different business model than traditional insurance.
  • The establishment of macro-prudential monitoring with appropriate insurance representation.
  • The strengthening of industry risk management practices to build on the lessons learned by the industry and the sharing experiences with supervisors on a global scale.

Since the publication of The Geneva Association statement, in June 2010, the International Association of Insurance Supervisors (IAIS) issued its position statement on key financial stability issues. A key conclusion of the statement was that, “The insurance sector is susceptible to systemic risks generated in other parts of the financial sector. For most classes of insurance, however, there is little evidence of insurance either generating or amplifying systemic risk, within the financial system itself or in the real economy.”[20]

Other organisations such as the CEA and the Property Casualty Insurers Association of America (PCI)[21] have issued reports on the same subject.

Discussion Edit

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 the US government has debated how to address financial services regulatory reform and systemic risk.[22][23]

Further readingEdit

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  • Andreas A. Jobst, 2012, "Systemic Risk in the Insurance Sector-General Issues and a First Assessment of Large Commercial (Re-)Insurers in Bermuda," Working paper (March 14).
  • Dale F. Gray and Andreas A. Jobst, 2011, "Modelling Systemic Financial Sector and Sovereign Risk," Sveriges Riksbank Economic Review, No. 2, pp. 68–106.
  • Dale F. Gray and Andreas A. Jobst, 2009, "Higher Moments and Multivariate Dependence of Implied Volatilities from Equity Options as Measures of Systemic Risk,” Global Financial Stability Report, Chapter 3, April (Washington: International Monetary Fund), pp. 128–31.
  • Dale F. Gray and Andreas A. Jobst, “New Directions in Financial Sector and Sovereign Risk Management, Journal of Investment Management, Vol. 8, No.1, pp.23-38.
  • Dale F. Gray and Andreas A. Jobst, 2011, “Modeling Systemic and Sovereign Risk,” in: Berd, Arthur (ed.) Lessons from the Financial Crisis (London: RISK Books), pp. 143–85.
  • Dale F. Gray and Andreas A. Jobst, 2011, “Systemic Contingent Claims Analysis – A Model Approach to Systemic Risk,” in: LaBrosse, John R., Olivares-Caminal, Rodrigo and Dalvinder Singh (eds.) Managing Risk in the Financial System (London: Edward Elgar), pp. 93–110.
  • Gray, Dale F., Andreas A. Jobst, and Samuel Malone, 2010, “Quantifying Systemic Risk and Reconceptualizing the Role of Finance for Economic Growth,” Journal of Investment Management, Vol. 8, No.2, pp. 90–110.
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  • Zeyu Zheng, Boris Podobnik, Ling Feng and Baowen Li, "Changes in Cross-Correlations as an Indicator for Systemic Risk" (Scientific Reports 2: 888 (2012)).

ReferencesEdit

See alsoEdit

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