Systemic risk

In finance, Systemic Risk is that risk which is common to an entire market and not to any individual entity or component thereof. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries" [ https://www.newyorkfed.org/registration/research/risk/Daula_slides.ppt Systemic Risk: Relevance, Risk Management Challenges and Open Questions. Tom Daula] . It refers to the movements of the whole economy and has wide ranging effects. It is also sometimes erronously referred to as "systematic risk".

Explanation

The easiest way to understand Systemic Risk is as the inverse of a (protective) policy. Just as governments and market monitoring insitutions (such as the SEC, SEBI etc.) put policies and rules in place to safeguard interests of the markets, all the participants are entangled in a web of dependencies arising from sharing exposure to the same economic factors and from being under the control of same regulation mechanisms.

Systemic Risk should not be confused with market 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.

In insurance it is difficult to obtain financial protection against "systemic risks" because of the inability of any counter-party to accept the risk. 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. "Systemic Risk" adds the important problem that it 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, data on "Systemic Risk" is often hard to obtain, since interdependencies and counter party risk on financial markets play a crucial role. 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 some 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. [ [http://www.independent.org/pdf/tir/tir_07_3_scott.pdf What is Systemic Risk] ]

Factors

Factors that are found to support systemic riskscite web |url=http://books.google.co.in/books?id=DuWRmiB3QRMC&pg=PA26&lpg=PA26&dq=causes+of+systemic+risk&source=web&ots=iQ6KkmHYUU&sig=Qqot1DVSeNM-qZLX2D0CWdPkrFk&hl=en&sa=X&oi=book_result&resnum=3&ct=result#PPA27,M1 |title=Risk management and capital adequacy |accessdate=2008-09-18 |author=Reto R. Gallati] are:
# 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.
# 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

Risks can be reduced in four main ways: Avoidance, Reduction, Retention and Transfer. Systemic risk is a risk of security that cannot be reduced through diversification. Also sometimes called market risk or un-diversifiable risk. Participants in the market, like hedge funds, can themselves be the source of an increase in systemic risk [ [http://web.mit.edu/alo/www/Papers/systemic2.pdf Systemic risk and hedge funds] ] and transfer of risk to them may, paradoxically, increase the exposure to systemic risk.

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 cannot be the sole protection against systemic risks.cite web |url=http://finance.wharton.upenn.edu/~allenf/download/Vita/systemicriskrevised.pdf |title=Systemic Risk and Regulation |accessdate=2008-09-18 |author=Franklin Allen and Douglas Gale]

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. [ [http://www.c4ce.com/AACE_Risk_Hollmann_paper.pdf Systemic Risks in Projects] ]

References

ee also

*Modern portfolio theory
*Capital asset pricing model
*Risk modeling


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