Dynamics of Systemic Risk

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A systemic risk is a risk capable of affecting the function or even the survival of an entire system. A systemic crisis is an expression denoting a systemic change of scale, an overall consideration of a mechanism failure and its causes. And thus includes the environment within which it operates.

It is the probability of occurrence of a malfunction paralyzing the entire financial system in a large area or worldwide, through cross-exposures. This would lead to a collapse of global financial system. It is opposed to non-systemic risk, which describes the risks that arise when the global economy faces a major external event (such as a war).

In recent years the concept is part of the jargon in the economy that has taken over in the discussion of evolutionary behavioral development. Systemic risks can not be covered by insurance companies, because it is capable of affecting all market participants, hence, it is difficult to find an insurance contract adequately covering it.

For instance, it is difficult to find a life insurance which can cover nuclear war risks. The essence of beating the systemic risk is thus the strong correlation of losses of all parties.

The other challenge that insurers face is that of risk assessment, much more difficult than in the case of non-systemic risk – obtaining data on systemic risk can be daunting. If a bank declares bankruptcy and sells all its assets, the fall in asset prices can introduce liquidity problems to other banks, leading to a general panic.

Another issue in this context is the strong potential vulnerability of the monetary economy in the extraordinary crisis. In which the function of financial markets is threatened. If financial market participants handle financial transactions, which exceed the available underlying securities traded (speculative trading in derivatives or hedge funds).

Then there will be a failure overthrow regarding large market participants, and others in illiquidity. Thus creating a domino effect which exposes the whole market system to the risk of collapse.

On the other hand, the financial markets and the volume of traded contracts serve to hedge risk by increasing volume. Thus financial markets are not only potential sources of risk, but are also capable of risk protection.

The banks hold enough capital to absorb credit risk, market risk and operational risk. Following the recent development of derivatives markets, it is clear that banks have a greater tendency to sell their credit risk. This is called securitization.

This risk can be mitigated in four main ways by avoiding, reducing, withholding or transferring it. Systemic risk is a risk that can not be reduced by diversifying hence it is sometimes called non-diversifiable risk. The financial market participants may themselves be a source of increased systemic risk, and transfer the risk  paradoxically, increasing systemic risk.

One of the main reasons for the regulation of financial markets is precisely to reduce systemic risk. Only the central banks in their role as lender of last resort, are able to remedy it whenever it materializes.

 

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