Academic journal article Federal Reserve Bank of New York Economic Policy Review

Systemic Risk and the Financial System

Academic journal article Federal Reserve Bank of New York Economic Policy Review

Systemic Risk and the Financial System

Article excerpt

Introduction

This paper is intended as background material for a cross-disciplinary conference, sponsored by the Board on Mathematical Sciences and Their Applications of the National Academy of Sciences and the Federal Reserve Bank of New York, on new approaches to evaluating systemic risks and managing systemic events in the global financial system. A key objective of the conference is to bring together a diverse group of leading researchers who have developed analytical tools for the study of complex systems in a range of fields of inquiry.

The stability of the financial system and the potential for systemic risks to alter the functioning of that system have long been important topics for central banks and for the related research community. However, recent experiences, including the market disruption following the attacks of September 11, 2001, suggest that existing models of systemic shocks in the financial system may not adequately capture the propagation of major disturbances. For example, current models do not fully reflect the increasing complexity of the financial system's structure, the complete range of financial and information flows, and the diverse nature of the endogenous behavior of different agents in the system. Fresh thinking about systemic risk is therefore desirable.

This paper describes the broad features of the global financial system and the models with which researchers and central bankers have typically approached the issues of financial stability and systemic risk--information that can serve as a shared reference for conference participants. The conference itself will provide an opportunity for participants to discuss related research in other fields and to draw out potential connections to financial system mechanisms and models, with the ultimate goal of stimulating new ways of thinking about systemic risk in the financial system.

Systemic risk is a difficult concept to define precisely. A recent report by the Group of Ten (2001) on financial sector consolidation defined systemic risk as "the risk that an event will trigger a loss of economic value or confidence in, and attendant increases in uncertainty about, a substantial portion of the financial system that is serious enough to quite probably have significant adverse effects on the real economy." This definition is broad enough to permit different views on whether certain recent episodes within the financial system constituted true systemic risk or only threatened to become systemic if they had a significant adverse impact on the real economy.

Some argue that even damage to the real economy is not sufficient grounds to classify an episode as systemic; rather, the key characteristic of systemic risk is the movement from one stable (positive) equilibrium to another stable (negative) equilibrium for the economy and financial system. According to this view, research on systemic risk should focus on the potential causes and propagation mechanisms for the "phase transition" to a new but much less desirable equilibrium as well as the "reinforcing feedbacks" that tend to keep the economy and financial system trapped in that equilibrium.

While differences in the definition of systemic risk are clearly important from a policymaking perspective, this paper includes discussions of episodes that not everyone would agree were systemic in nature. This is because our primary interest is in stimulating further research on the types of propagation or feedback mechanisms that might cause a small financial shock to become a major disturbance, allow a financial shock to have a material impact on the real economy, or mire the financial system in a suboptimal equilibrium. In this regard, the dynamics of nonsystemic episodes may still be very relevant to the modeling of financial market behavior. Moreover, as noted by a recent private sector report on risk management practices (Counterparty Risk Management Policy Group II 2005), "Unfortunately, in real time it is virtually impossible to draw such distinctions. …

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