Systemic Risk
What is Systemic Risk?
Systemic risk is the danger that one institution's or market's failure spreads through the financial system and disrupts credit for the whole economy.
Three features turn an individual failure into a system wide event: institutions lend to each other so losses travel along counterparty chains, many firms hold the same assets so one shock hits everyone at once, and short term funding backs long term assets so a loss of confidence forces immediate selling. Fire sales are the amplifier, because a distressed seller pushes prices down, which marks down the portfolios of every other holder and forces them to sell in turn. The behaviour is a negative externality: each firm sets its leverage by weighing only its own chance of failure and ignores the damage that failure would do to others, so the market produces more leverage and less liquidity than is safe in aggregate. Regulators answer with capital and liquidity minimums, surcharges on the largest banks, stress tests, central clearing of derivatives and resolution plans. The concept resists measurement, since correlations estimated in calm periods understate how tightly assets move together once a panic starts.
Systemic Risk: a worked example
A bank holds $100 billion of assets funded by $6 billion of equity and $94 billion of borrowing, so leverage is 100 divided by 6, about 16.7 to 1. Asset values fall 4 percent, a loss of $4 billion, and the loss lands entirely on equity: equity drops to $2 billion, assets to $96 billion, and leverage jumps to 96 divided by 2, or 48 to 1. To get back to 16.7 to 1 the bank can hold only 16.7 times $2 billion, about $33.3 billion of assets, so it must sell roughly $62.7 billion and repay debt. A 4 percent price move has forced the sale of nearly two thirds of the balance sheet. If ten similar banks hold similar portfolios and all rebalance together, about $627 billion hits the market at once, driving prices down further and starting the next round of losses.
The mistake students make with systemic risk
Systemic risk gets swapped with systematic risk, and they are different things. Systematic risk is the undiversifiable part of a single asset's return that comes from broad market movements, the beta term in a portfolio model, and every investor carries some of it. Systemic risk is the chance that the financial system itself stops clearing payments and allocating credit, which is a property of the network rather than of any one asset. A second error assumes an institution that looks individually safe cannot add to systemic risk, when a crowd of well capitalised firms holding the same asset and selling it simultaneously is precisely the problem.
Systemic Risk questions
What is the difference between systemic risk and systematic risk?
Systematic risk is market risk: the portion of an asset's return driven by broad market movements, which diversification cannot remove and which the beta of a portfolio measures. Systemic risk is the possibility that the financial system as a whole stops functioning, so payments, credit and funding seize up and the damage spreads into the real economy. The first is a property of an asset relative to the market, the second is a property of the network of institutions and their exposures to each other.
How do regulators try to reduce systemic risk?
The main tools raise the loss absorbing capacity of the system and lower the chance that trouble spreads. Banks must hold minimum capital and liquid assets, the largest and most interconnected face extra capital surcharges, and stress tests check whether they would survive a severe downturn. Regulators also route derivatives through central clearing houses so exposures are netted and visible, require resolution plans so a failing firm can be wound down without a bailout, and vary capital buffers over the credit cycle.
Why is a bank being too big to fail a systemic risk problem?
A firm that lenders expect to be rescued borrows more cheaply than its actual risk warrants, because the price reflects the rescue rather than the risk. That implicit subsidy encourages the firm to take on more leverage and grow larger, which makes an eventual rescue both more likely and more expensive, a textbook case of moral hazard. Size alone is not the trigger: interconnection, complexity and being the sole provider of some service can make a much smaller firm systemically important too.
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