Systemic risk

What is Systemic Risk?

In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system, that can be contained therein without harming the entire 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 interlinkages and interdependencies in a system or market, where the failure of a single entity or cluster of entities can cause a cascading failure, which could potentially bankrupt or bring down the entire system or market. It is also sometimes erroneously referred to as “systematic risk”.

Systemic risk is the possibility that an event at the company level could trigger severe instability or collapse an entire industry or economy. Systemic risk was a major contributor to the financial crisis of 2008. Companies considered a systemic risk are called “too big to fail.” These institutions are very large relative to their respective industries or make up a significant part of the overall economy. A company that is highly interconnected with others is also a source of systemic risk. Systemic risk should not be confused with systematic risk.

Explanation of Systemic Risk

Systemic risk became a key concept during the Global Financial Crisis (GFC). Systemic risk is the possibility that an event at the micro level of an individual bank / insurance company for example could then trigger instability or collapse an entire industry or economy.

Systemic risk has been associated with a bank run which has a cascading effect on other banks which are owed money by the first bank in trouble, causing a cascading failure. As depositors sense the ripple effects of default, and liquidity concerns cascade through money markets, a panic can spread through a market, with a sudden flight to quality, creating many sellers but few buyers for illiquid assets. These interlinkages 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 U.S. Securities and Exchange Commission (SEC), and central banks) often try to put policies and rules in place with the justification of safeguarding the interests of the market as a whole, claiming that the trading participants in financial markets are entangled in a web of dependencies arising from their interlinkage. In simple English, this means that some companies are viewed as too big and too interconnected to fail. Policy makers frequently claim that they are concerned about protecting the resiliency of the system, rather than any one individual in that system. Systemic risk arises because of the interaction of market participants, and therefore can be seen as a form of endogenous risk.

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.

Insurance is often easy to obtain against “systemic risks” because a party issuing that insurance can pocket the premiums, issue dividends to shareholders, enter insolvency proceedings if a catastrophic event ever takes place, and hide behind limited liability. Such insurance, however, is not effective for the insured entity.

One argument that was used by financial institutions to obtain special advantages in bankruptcy for derivative contracts was a claim that the market is both critical and fragile.

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.

A general definition of systemic risk which is not limited by its mathematical approaches, model assumptions or focus on one institution, and which is also the first operationalizable definition of systemic risk encompassing the systemic character of financial, political, environmental, and many other risks, was put forth in 2010.

The Systemic Risk Centre at the London School of Economics is focused on the study of systemic risk. It finds that systemic risk is a form of endogenous risk, hence frustrating empirical measurements of systemic risk.

The Difference Between Systemic Risk and Systematic Risk

Systemic risk is generally used in reference to an event that can trigger a collapse in a certain industry or economy, whereas systematic risk refers to overall market risk. Systemic risk does not have an exact definition, many have used systemic risk to describe narrow problems, such as problems in the payments system, while others have used it to describe an economic crisis that was triggered by failures in the financial system. Generally, systemic risk can be described as a risk caused by an event at the firm level that is severe enough to cause instability in the financial system.

On the other hand, systematic risk does have a more recognized and universal definition. Sometimes plainly called market risk, systematic risk is the risk inherent in the aggregate market that cannot be solved by diversification. Some common sources of market risk are recessions, wars, interest rates and others that cannot be avoided through a diversified portfolio. Though systematic risk cannot be fixed with diversification, it can be hedged. Also, the risk that is specific to a firm or industry and can be solved by diversification is called unsystematic or idiosyncratic risk.

Measurement of Systemic Risk

TBTF/TICTF

According to the Property Casualty Insurers Association of America, there are two key assessments for measuring systemic risk, the “too big to fail” (TBTF) and the “too interconnected to fail” (TICTF) tests. First, the TBTF test is the traditional analysis for assessing the risk of required government intervention. TBTF can be measured in terms of an institution’s size relative to the national and international marketplace, market share concentration, and competitive barriers to entry or how easily a product can be substituted. Second, the TICTF test 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 measure beyond the institution’s products and activities to include the economic multiplier of all other commercial activities dependent specifically on that institution. The impact is also dependent on how correlated an institution’s business is with other systemic risks.

TBTF

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 relatively 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. During the recent financial crisis, the collapse of the American International Group (AIG) posed a significant systemic risk to the financial system. There are arguably either no or extremely few insurers that are TBTF in the U.S. marketplace.

TICTF

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. Network models have been proposed as a method for quantifying the impact of interconnectedness on systemic risk. 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 institution’s business is with other systemic risk.

Criticisms of systemic risk measurements

Criticisms of systemic risk measurements: express concerns about systemic risk measurements, such as SRISK and CoVaR, because they are based on market outcomes that happen multiple times a year, so that the probability of systemic risk as measured does not correspond to the actual systemic risk in the financial system. Systemic financial crises happen once every 43 years for a typical OECD country and measurements of systemic risk should target that probability.

SRISK

A financial institution represents a systemic risk if it becomes undercapitalized when the financial system as a whole is undercapitalized. In a single risk factor model, Brownlees and Engle, build a systemic risk measure named SRISK. SRISK can be interpreted as the amount of capital that needs to be injected into a financial firm as to restore a certain form of minimal capital requirement. SRISK has several nice properties: SRISK is expressed in monetary terms and is, therefore, easy to interpret. SRISK can be easily aggregated across firms to provide industry and even country specific aggregates. Last, the computation of SRISK involves variables which may be viewed on their own as risk measures, namely the size of the financial firm, the leverage (ratio of assets to market capitalization), and a measure of how the return of the firm evolves with the market (some sort of time varying conditional beta but with emphasis on the tail of the distribution). Because these three dimensions matter simultaneously in the SRISK measure, one may expect to obtain a more balanced indicator than if one had used either one of the three risk variables individually.

Whereas the initial Brownlees and Engle model is tailored to the US market, the extension by Engle, Jondeau, and Rockinger allows for various factors, time varying parameters, and is therefore more adapted to the European market. One factor captures worldwide variations of financial markets, another one the variations of European markets. Then this extension allows for a country specific factor. By taking into account different factors, one captures the notion that shocks to the US or Asian markets may affect Europe but also that bad news within Europe (such as the news about a potential default of one of the countries) matters for Europe. Also, there may be country specific news that do not affect Europe nor the USA but matter for a given country. Empirically the last factor is found to be less relevant than the worldwide or European factor.

Since SRISK is measured in terms of currency, the industry aggregates may also be related to Gross Domestic Product. As such one obtains a measure of domestic systemically important banks.

The SRISK Systemic Risk Indicator is computed automatically on a weekly basis and made available to the community. For the US model SRISK and other statistics may be found under the Volatility Lab of NYU Stern School website and for the European model under the Center of Risk Management (CRML) website of HEC Lausanne.

Pair/Vine Copulas

A vine copula can be used to model systemic risk across a portfolio of financial assets. One methodology is to apply the Clayton Canonical Vine Copula to model asset pairs in the vine structure framework. As a Clayton copula is used, the greater the degree of asymmetric (i.e., left tail) dependence, the higher the Clayton copula parameter. Therefore, one can sum up all the Clayton Copula parameters, and the higher the sum of these parameters, the greater the impending likelihood of systemic risk. This methodology has been found to detect spikes in the US equities markets in the last four decades capturing the Oil Crisis and Energy Crisis of the 1970s, Black Monday and the Gulf War in the 1980s, the Russian Default/LTCM crisis of the 1990s, and the Technology Bubble and Lehman Default in the 2000s.

Factors of Systemic Risk

Factors that are found to support systemic risks are:

  1. Economic implications of models are not well understood. Though each individual model may be made accurate, the facts that (1) all models across the board use the same theoretical basis, and (2) the relationship between financial markets and the economy is not known lead to aggravation of systemic risks.
  2. Liquidity risks are not accounted for in pricing models used in trading on the financial markets. Since all models are not geared towards this scenario, all participants in an illiquid market using such models will face systemic risks.

Diversification of Systemic Risk

Risks can be reduced in four main ways: avoidance, diversification, hedging and insurance by transferring risk. Systematic risk, also called market risk or un-diversifiable risk, is a risk of a security that cannot be reduced through diversification. Participants in the market, like hedge funds, can be the source of an increase in systemic risk and the transfer of risk to them may, paradoxically, increase the exposure to systemic risk.

Until recently, many theoretical models of finance pointed towards the stabilizing effects of a diversified (i.e., dense) financial system. Nevertheless, some recent work has started to challenge this view, investigating conditions under which diversification may have ambiguous effects on systemic risk. Within a certain range, financial interconnections serve as a shock-absorber (i.e., connectivity engenders robustness and risk-sharing prevails). But beyond the tipping point, interconnections might serve as a shock-amplifier (i.e., connectivity engenders fragility and risk-spreading prevails).

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 of only one industry cannot be the sole protection against systemic risks.

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.