What is systemic risk?

Systemic risk arises when the financial sector's need to equity or liquidity is not met.

As COVID-19 depressed economies, systemic risk is back on the agenda. What is systemic risk? How does it cause financial crises? How could authorities control systemic risk?

As liquidity dries in the market, some financial agencies default on their short-term liabilities although they possess long-term assets that cover all their liabilities. As defaults on loans staggeringly rise in an economic downturn, some financial agencies become insolvent.

Once more, COVID-19 activated the fear that financial agencies might become short of liquidity and equity.

Systemic risk arises as a result of the need either to equity or liquidity. As liquidity dries in the market, some financial agencies default on their short-term liabilities although they possess long-term assets that cover all their liabilities. As defaults on loans staggeringly rise in an economic downturn, some financial agencies become insolvent. That is, their assets do not cover their liabilities.

The financial sector doesn't fall itself, but it pulls the entire economy down. Financial agencies cannot supply loans in case they face a liquidity or equity shortage. In these conditions, they try to keep all resources for themselves in order to be able to meet their short-term liabilities. Furthermore, they squeeze credits in order to preserve their equities. Credit rationing negatively reflects to households and firms.

Once more, COVID-19 activated the fear that financial agencies might become short of liquidity and equity. In terms of liquidity, the Fed saturated markets until now. Nevertheless, the upcoming recession will severely jeopardize equities of financial agencies. Monetary policy does not have the tools to resolve an equity shortage. If a financial agency becomes insolvent, fiscal authorities will need to rescue it.

Systemic risk is detected, measured, regulated and supervised by the macroprudential approach. Success of the macroprudential policies depends on various independent factors, which are not under control. To name those factors, first, systemic risk might not be measured as it is. Risk measurement tools such as stress tests depend on the predetermined parameters. As in the case of the last global financial crisis, if an undefined risk grows and remains undetected by the regulatory bodies, a new financial crisis might occur again.

Second, managing systemic risk requires regulatory bodies to impose costly measures on the financial system such as capital and liquidity requirements leading the financial institutions to keep more idle money in their vaults. As in the case of the 2008 global financial crisis, new actors, such as non-banks, might grow on the lending side of the economy outside the supervision. Since 2008, non-banks can grew over the average of the financial sector as they can lend cheaper money with higher leverages and lower liquidity compared to the banks.

Third, political pressure can block necessary regulations. Both an undefined risk and an unregulated financial institution would contribute to the short-term welfare of the society at the cost of long-term benefits, so governments would be reluctant to intervene in such situations. In normal times, interfering with a lender offering cheaper interest rates would not be a popular action for the legislators.

Emerging risks are well known to the regulatory bodies. However, being aware of a risk does not imply to be able to manage it in every sense. New risks and new financial institutions may emerge as a result of finding new ways to tackle regulations. In this case, regulatory bodies may require additional authority. Yet, as long as the economic trend is upwards, the sought political support cannot be provided easily until a crisis severely hits the economy.

References

John Armour, Dan Awrey, Paul Davies, Luca Enriques, Jeffrey Gordon, Colin Mayer and Jennifer Payne, 1999, Principles of Financial Regulation (Oxford: Oxford University Press), pp. 409-430.