Systemic risk
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In finance, systemic risk is risk associated with the possibility of a collapse of the financial system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries"[1]. It should be distinguished from systematic risk which refers to risk associated with movements in the market as a whole.
Contents
Explanation
In insurance it is difficult to obtain financial protection against "systemic risks" because of the inability of any counter-party to accept the risk. 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. "Systemic Risk" adds the important problem that it 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, data on "Systemic Risk" is often hard to obtain, since interdependencies and counter party risk on financial markets play a crucial role. 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.
One concern is the potential fragility of some financial markets. 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.[2]
Factors
Factors that are found to support systemic risks[3] are:
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[4] 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. 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.[5]
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.[6]
Addressing Systemic Risk
According to Nobel laureate Dr. A. Michael Spence, "systemic risk escalates in the financial system when formerly uncorrelated risks shift and become highly correlated. When that happens, then insurance and diversification models fail. There are two striking aspects of the current [2008] crisis and its origins. One is that systemic risk built steadily in the system. The second is that this buildup went either unnoticed or was not acted upon. That means that it was not perceived by the majority of participants until it was too late. Financial innovation, intended to redistribute and reduce risk, appears mainly to have hidden it from view. An important challenge going forward is to better understand these dynamics as the analytical underpinning of an early warning system with respect to financial instability." [7]
