Monday, March 02, 2009

Systemic risk defined--Too Big to Fail

Systemic risk is the risk of collapse of an entire system or entire market and not to any one individual entity or component of that system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries". It refers to the risks imposed by inter-linkages and inter-dependencies in a system or market, which could potentially bankrupt or bring down the entire system or market if one player is eliminated, or a cluster of failures occurs at once.[3] It is also sometimes erroneously referred to as "systematic risk".

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The easiest way to understand systemic risk is to consider a bank run which has a cascading effect on other banks which are owed money by the first bank in trouble. As depositors sense the ripple effects of default, and liquidity concerns cascade through money markets, a panic can spread through a market, creating many sellers but few buyers. These inter-linkages 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. Governments and market monitoring institutions (such as the SEC, and central banks) often try to put policies and rules in place to safeguard the interests of the market as a whole, as all the trading participants in financial markets are entangled in a web of dependencies arising from their inter-linkages and often policy makers are concerned to protect the resiliency of the system, rather than any one individual in that system. Sometimes "picking winners" and protecting favored individual participants in a system can engender moral hazard in a system and weaken the resilience of the system as a whole.

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.

Consider a portfolio of perfectly hedged investments, we can say that the market risk of this portfolio is nullified. Yet, if there is a downturn in the economy and the market as a whole sinks, the hedges would not be of use. This is the systemic risk to the portfolio.

Insurance is often difficult to obtain against "systemic risks" because of the inability of any counterparty to accept the risk or mitigate against it, because, by definition, there is likely to be no (or very few) solvent counterparties in the event of a systemic crisis. 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. Because of the inter-dependencies between market participants, an event triggering systemic risk 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, good analysis on "systemic risk" protection is often hard to obtain, since inter-dependencies and counterparty risk in financial markets play a crucial role in times of systemic stress, and the interaction between interdependent market players is extremely difficult (or impossible) to model accurately. 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 liquidity in some highly leveraged 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.

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.

Measurement of Systemic Risk

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 realtively 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 instituion's business is with other systemic risk.

Bob DeMarco is a citizen journalist, blogger, and Caregiver. In addition to being an experienced writer he taught at the University of Georgia , was an Asociate Director and Limited Partner at Bear Stearns, was CEO of IP Group, and is a mentor. Bob currently resides in Delray Beach, FL where he cares for his mother, Dorothy, who suffers from Alzheimer's disease. Bob has written more than 500 articles with more than 11,000 links to his work on the Internet. His content has been syndicated on Reuters, the Wall Street Journal, Fox News, Pluck, BlogCritics, and a growing list of newspaper websites (15). Bob is actively seeking syndication and writing assignments.