Academic journal article Independent Review

What Is Systemic Risk, and Do Bank Regulators Retard or Contribute to It?

Academic journal article Independent Review

What Is Systemic Risk, and Do Bank Regulators Retard or Contribute to It?

Article excerpt

One of the most feared events in banking is the cry of systemic risk. It matches the fear of a cry of "fire!" in a crowded theater or other gatherings. But unlike fire, the term systemic risk is not clearly defined. Moreover, unlike firefighters, who rarely are accused of sparking or spreading rather than extinguishing fires, bank regulators at times have been accused of contributing to, albeit unintentionally, rather than retarding systemic risk. In this article, we discuss the alternative definitions and sources of systemic risk, review briefly the historical evidence of systemic risk in banking, describe how participants in financial markets traditionally have protected themselves from systemic risk, evaluate the regulations that bank regulators have adopted to reduce both the probability of systemic risk and the damage it causes when it does occur, and make recommendations for efficiently curtailing systemic risk in banking.

Systemic Risk

Systemic risk refers to the risk or probability of breakdowns in an entire system, as opposed to breakdowns in individual parts or components, and is evidenced by comovements (correlation) among most or all the parts. Thus, systemic risk in banking is evidenced by high correlation and clustering of bank failures in a single country, in a number of countries, or throughout the world. Systemic risk also may occur in other parts of the financial sector--for example, in securities markets as evidenced by simultaneous declines in the prices of a large number of securities in one or more markets in a single country or across countries. Systemic risk may be domestic or transnational.

Definitions of Systemic Risk in Banking

The precise meaning of systemic risk is ambiguous; it means different things to different people. A search of the literature reveals three frequently used concepts. The first refers to a "big" shock or macroshock that produces nearly simultaneous, large, adverse effects on most or all of the domestic economy or system. Here, systemic "refers to an event having effects on the entire banking, financial, or economic system, rather than just one or a few institutions" (Bartholomew and Whalen 1995, 4). Likewise, Frederic Mishkin defines systemic risk as "the likelihood of a sudden, usually unexpected, event that disrupts information in financial markets, making them unable to effectively channel funds to those parties with the most productive investment opportunities" (1995, 32). How the transmission of effects from a macroshock to individual units, or contagion, occurs and which units are affected are generally unspecified. Franklin Allen and Douglas Gale (1998) model one process through which macroshocks can ignite bank runs.

The other two definitions focus more on the microlevel and on the transmission of the shock and potential spillover from one unit to others. For example, according to the second definition, systemic risk is the "probability that cumulative losses will accrue from an event that sets in motion a series of successive losses along a chain of institutions or markets comprising a system.... That is, systemic risk is the risk of a chain reaction of falling interconnected dominos" (Kaufman 1995 a, 47). This definition is consistent with that of the Federal Reserve (the Fed). In the payments system,

    systemic risk may occur if an institution participating on a private
    large-dollar payments network were unable or unwilling to settle its net
    debt position. If such a settlement failure occurred, the institution's
    creditors on the network might also be unable to settle their commitments.
    Serious repercussions could, as a result, spread to other participants in
    the private network, to other depository institutions not participating in
    the network, and to the nonfinancial economy generally. (Board of
    Governors of the Federal Reserve System 2001, 2)

Likewise, the Bank for International Settlements (BIS) defines systemic risk as "the risk that the failure of a participant to meet its contractual obligations may in turn cause other participants to default with a chain reaction leading to broader financial difficulties" (BIS 1994, 177). …

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