Streamline Training & Documentation: Why Systemic Risk is Relatively High in the Financial Sector

Friday, September 18, 2009

Why Systemic Risk is Relatively High in the Financial Sector

If you'd like a refresher on the causes of the financial crisis, the Federal Reserve Bank of St. Louis has published an accessible recap in the September/October issue of their Review.

"Systemic Risk and the Financial Crisis: A Primer", by the St Louis Fed's CEO, James Bullard, and two economists at the Bank, Christopher J. Neely and David C. Wheelock, also explains "why the failures of financial firms are more likely to pose systemic risks than the failures of nonfinancial firms," and discusses remedies that have been suggested to better manage systemic risk in the future.

Because understanding what's unique about systemic risk in the financial sector is important for evaluating proposed policy changes affecting the sector, that's what I'll focus on in this post. The whole article is only twelve pages long and well worth a look.

First of all, here's the definition of systemic risk that Bullard, Neely, and Wheelock (BNW) use:

the risk that a triggering event, such as the failure of a large financial firm, will seriously impair financial markets and harm the broader economy.

BNW cite three reasons why the level of systemic risk is relatively high in the financial sector:

Interconnectedness among firms — The volume of inter-firm lending and trading transactions is high, the speed of transactions is rapid, and the "complex structures of many banks and securities firms make it especially difficult for a firm to fully monitor the counterparties with which it deals, let along the counterparties of counterparties." The upshot is elevated settlement risk — "the risk that one party to a financial transaction will default after the other party has delivered."

Firms' high levels of leverage — Financial firms finance a significantly higher percentage of their assets (e.g., holdings of mortgage-backed securities) through borrowing than do typical nonfinancial firms. The upshot is that financial firms are highly vulnerable to insolvency if their assets experience a downward slide in value due, say, to bursting of a real estate bubble.

Financing relatively illiquid investments with short-term debt — For example, commercial banks finance much of their lending, for which maturities are measured in years, by customer demand deposits (checking accounts), which are generally subject to withdrawal at a moment's notice. The upshot of this mismatch between the maturity of assets and the maturity of debt is that financial firms face elevated interest rate risk (the risk of having to pay a higher interest rate as existing short-term debt matures and is replaced with new borrowing) and liquidity risk (the risk of having to raise cash by selling assets during a period when asset prices are depressed, perhaps because buyer confidence is low).¹

As BNW explain in a footnote, "Systemic risk constitutes a 'negative externality' in the sense that the actions of one firm harm others. ... Negative externalities are an example of a market failure that may require government intervention to ameliorate." Proposals for changes in the regulatory regime for the financial sector will be under active discussion for the foreseeable future. BNW's article helps laypeople understand the issues and market dynamics that are at the heart of the discussion.

__________
¹ During a financial crisis, lenders may withdraw from the credit markets entirely due to uncertainty about counterparty reliability and solvency, future interest rate conditions, and collateral values. In this situation, which we have seen during the current crisis, new borrowing is effectively impossible.

###

Labels: Risk management, Systems thinking

<< Home