What is Systemic Risk?

What is Systemic Risk?

Systemic risk refers to the risk of a breakdown of an entire system rather than simply the failure of individual parts. In a financial context, it denotes the risk of a cascading failure in the financial sector, caused by linkages within the financial system, resulting in a severe economic downturn. A key question for policymakers is how to limit the build-up of systemic risk and contain economic crises events when they do happen.

Reducing the likelihood and severity of future financial crises can be ensured by a coordinated global effort to monitor market trends and bubbles, and to end government bailouts for failing financial institutions.

Understanding Systemic Risk

The federal government uses systemic risk as a justification—an often correct one—to intervene in the economy. The basis for this intervention is the belief that the government can reduce or minimize the ripple effect from a company-level event through targeted regulations and actions.

However, sometimes the government will choose not to intervene simply because the economy at that time had undergone a major rise and the general market needs a breather. This is more often the exception than the rule, since it can destabilize an economy more than projected due to consumer sentiment.

Prevention of Systemic Risk

The ripple effect resulting from systemic risk can bring down an economy. Controlling systemic risk is a major concern for regulators, particularly given that consolidation in the banking system has led to the creation of very large banks.

Following the 2008 global crisis, financial regulators began to focus on making the banking system less vulnerable to economic shocks. They created firewalls to prevent damage from systemic risk. Regulators also developed prudent microeconomic and macroeconomic policies with increased emphasis on prudential regulation, putting in place safeguards for the stability of the financial system.

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Macro-prudential regulation seeks to safeguard banks or the financial system as a whole. Micro-prudential regulations involve the regulation of individual financial firms such as commercial banks, payday lenders, and insurance companies.

Regulation of Systemic Risk

In the United States, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) created an Office of Financial Research (OFR) to monitor global market developments that might lead to systemic failure. The OFR is part of the US Department of the Treasury and supports the Financial Services Oversight Committee of federal financial regulators.

The Financial Stability Oversight Commission (FSOC) directs the OFR and requests data and analyses to support its members’ work. The FSOC also retains authority to deem nonbank institutions as systemically important financial institutions.

Despite warnings in Dodd-Frank that federal bailouts were a thing of the past, Dodd-Frank specifically authorizes the FDIC to guarantee the assets and liabilities of failing financial firms. It also calls on the Fed to create a list of systemically significant firms for special oversight.

The FDIC is an independent federal agency created by the US Congress in 1933 in response to the thousands of bank failures that occurred in the 1920s and early 1930s. Its role is to maintain stability and public confidence in the nation’s financial system by insuring commercial bank deposits; examining and supervising financial institutions for safety and soundness and consumer protection; making large and complex financial institutions resolvable; and managing receiverships.

A number of European and global entities have undertaken efforts to address systemic risk. For example, the G–20 nations agreed to reduce bank leverage by increasing the Basel III capital requirements for financial institutions. The European Union has worked to create a European Financial Stability Facility (EFSF) to provide temporary help to member states regarding fiscal debt burdens and fiscal deficits. The EFSF is a significant part of the €750 billion European Stabilization Mechanism to help member states.

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Global Regulatory Coordination for Managing Systemic Risk

Systemic risk management can be done by regional, national, or even global efforts. Since systemic risk can take down all or part of an economy, financial risk managers can access regulatory tools and legally binding recourse to manage threats within an economy.

For financial institution regulators, this includes the authority to examine equity returns, debt-risk premiums, deposit flows, and other exposures. The omnipresence of correlated assets and the way capital can move across sovereign borders, however, increases the risk of systemic contagion across the global system.

Examples of Systemic Risk

The Dodd-Frank Act of 2010, fully known as Dodd-Frank Wall Street Reform and Consumer Protection Act, introduced an enormous set of new laws that are supposed to prevent another Great Recession from occurring by tightly regulating key financial institutions to limit systemic risk. There has been much debate about whether changes need to be made to the reforms to facilitate the growth of small business.

Lehman Brothers’ size and integration into the U.S. economy made it a source of systemic risk. When the firm collapsed, it created problems throughout the financial system and the economy. Capital markets froze up while businesses and consumers could not get loans, or could only get loans if they were extremely creditworthy, posing minimal risk to the lender.

Simultaneously, AIG was also suffering from serious financial problems. Like Lehman, AIG’s interconnectedness with other financial institutions made it a source of systemic risk during the financial crisis. AIG’s portfolio of assets tied to subprime mortgages and its participation in the residential mortgage-backed securities (RMBS) market through its securities-lending program led to collateral calls, a loss of liquidity, and a downgrade of AIG’s credit rating when the value of those securities dropped.

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While the U.S. government did not bail out Lehman, it decided to bail out AIG with loans of more than $180 billion, preventing the company from going bankrupt. Analysts and regulators believed that an AIG bankruptcy would have caused numerous other financial institutions to collapse as well.