Exploring Systemic Risk And Its Significance In The Financial Sector

Definition of Systematic and Systemic Risk

According to Lee and Renner (2016), the risk that is intrinsic to the overall market or to an entire segment of market is termed as Systematic Risk. It has been found that this systematic risk is also termed as “undiversifiable risk” or “market risk” or “volatility” that impacts the entire market and not only the particular sector or stock. Therefore, this particular kind of risk is considered to be both unavoidable and unpredictable. Moreover, it can be said that this risk cannot be mitigated by the help of diversification, or through the process of hedging or by utilizing the particular strategy of asset allocation (Sharma 2015).

Definition of Systematic and Systemic Risk

Furthermore, it can be said that the systematic risk lies beneath all other risks that are related to investment. In addition to these, it can be said that the Great Recession is the main example of the systematic risk (Sutherland et al. 2015). It has been found that the investors, who invested in the market in the year 2008, noted that their investment values changed constantly due to the market-wide financial event (Masciandaro and Balakina 2016). Moreover, it has been detected that the Great Global Financial Crisis have affected various classes of assets in numerous manners, but the investors with a larger portfolio and broader allocation of assets were relatively less affected than the investors who only invested their money in the stocks.

Mathematically, the security risk of fund, portfolio or security is measured in terms of Beta that helps in calculating the process by which volatile investment is contrasted with the entire market. Generally, when the beta value is more than one, it implies that the investment has much systematic risk in comparison to the market, but when the value of beta is less than one, it implies that the systematic risk is less than the market. However, if the value of beta is equivalent to one, it implies that the rate of systematic risk is equivalent to the present market.  

On the contrary, the systemic risk in the world of finance is described as the risk of collapsing of an overall fiscal system or the whole market, as resisted to the risks that are related to any single individual entity, component or group of a system (Werner and Stoner 2015). This system can be enclosed in that without affecting the whole system. Therefore, the systemic risk is portrayed as the probability regarding an event in the level of the firm that could set off harsh instability or the collapse of the overall economy or industry. It can be said that in the global fiscal crisis of the year 2008, the systemic risk was a chief contributor (Coe, Lai and Wójcik 2014).

It has been found that the Federal government generally utilizes the systematic risk due to a rationalization to intercede in the financial system. However, it has been found that the base of this interference is the confidence that the particular government is able to deduce or to minimize the undulation effect from a firm-level event by targeting the actions and the regulations. For instance, the Act of Dodd-Frank of the year 2010 is a mammoth set of newer rules, regulations and laws that is generally believed to put off from occurring any other Great Recession by tightly operating the principle financial institutions for limiting the systematic risk (Anderson et al. 2014).

The Nature of Systemic Risk and Its Significance in the Financial Sector

Moreover, it can be said that the size of the firm Lehman Brothers and its incorporation into the financial system of the U.S. made it a resource for systematic risk. Therefore, when the particular organization collapsed, it created issues in the overall economy and financial system. During the period, the capital market froze up and thus, the clients as well as the businesses were unable to obtain loans, especially they were tremendously creditworthy by posturing negligible risk to the lender. In addition to these, it has been found that AIG was also undergoing severe economic problems (Rivoli 2014).

As per the Lehman Brothers, the interconnectedness of the firm AIG with the other fiscal firms made it a resource of the systematic risk, especially during the period of the global fiscal crisis. The portfolio of assets of AIG was tied to the subprime mortgages. This partaking in the market of residential mortgage-backed securities by the help of the program of securities-lending led to the loss of liquidity, downgrade of credit rating of the firm and the collateral cells, when the securities’ worth decreased. It has been found that the government of the U.S. did not bail out the firm Lehman Brothers but the government decided to bail out the firm AIG along with the loans of over $ 180 billion that puts off the firm from going under bankruptcy (Ways 2016).

Nature of Systemic Risk and its Significance in the Financial Sector

The nature of the systemic risk implies that the particular kind of risk that can lead to failure of the overall financial system and can create a general financial collapse, as divergent to the risk related to an individual portion of the system. As per Velle (2013), the systemic risk begins from the inter-association that is existed in the fiscal system. Here, the failure of a particular firm might lead to spillover and it can even cascade the failures that are intensified by the intrinsic pro-cyclicality of the regulations and banking. The particular situation of the systematic risk intends to be developed when all the noticeable signs point towards lower risk and stability.

Moreover, it has been found that there are no or a few recorded cases of a systemic occasion as per the stern definition. There are diverse measures that were closed for their brutality and other actions that if left to culmination might finish up as the systemic affair. Therefore, it is a significant factor to identify that whether there is no single accepted definition of the systemic risk. As per Parnell (2016), the systemic event can become global or it might just affect a particular country. It has been found that certain nations are more susceptible to the systemic risk than the others particularly that have based the economies on the finance and are exporters of the fiscal services. The significance of the systemic risk can be better understood from the following example and its graph:

The ECB (European Central Bank) of the EU (European Union) publishes that statistics based on the dimension of the banking system and thus have divided into two sectors – foreign and domestic portions. The following graph represents the relative dimension of the banking systems among the state members of the EU that helps to gauge the ratio between total banking assets and the GDP during pre and post global financial crisis period that are in the years 2007 and 2011 respectively (Bancel and Mittoo 2014).

Based on the above graph, it can be said that the country Romania has the smallest banking system that is only 64 %, whereas, the nations like Malta, Cyprus, Ireland and Luxembourg are considered as the largest banking nations. However, Cyprus and Ireland have been found to hit badly by the debt crisis of the European sovereign (Schwartz 2014). Nonetheless, this financial circumstance does not imply that the large banking nations are more defenseless to the systemic risk than the others (Spence et al. 2015). This indicates the degree to which the domestic system is domestically owed and the quantity that is foreign owned.

As per Anheier (2014), the nations with largest and smallest banking systems possess principally overseas banking system, although for various causes. However, for the smaller banking nations, the foreigners generally purchase the regular banks, whereas, for the larger banking nations, the foreign-purchased banks mainly serve the overseas customers (Calderon and Mathies 2013). Moreover, these nations have been found to export the banking services that are manufactured by the banks that are foreign-purchased.

Therefore, it can be said that this diminishes the vulnerability (Spence et al. 2015). For instances, if the properties of the banks of Luxembourg surplus the present GDP by twenty times, it has been found that Luxembourg will be comparatively insulted. The reason behind this is that the failure of the particular bank might not include the money of the taxpayers directly (Schwartz 2014). Nevertheless, if several banks of Luxembourg failed, then its government would find itself in the position of lack of money from the taxes and thus, these are directly associated with the banks. In spite of being these, this particular kind of threat is considered as lesser direct than the situation when Luxembourg would call on for bailing out the banks.

In addition to these, it can be said that the above figure also represents that the U.K. (the United Kingdom) had the 7^th largest position in the banking system of the E.U. in the year 2007 (Spence and Carter 2014). The significance of the banking system can be better understood from the following graph:

The above graph represents the importance as well as the output index of the UK. In addition, the economic growth comes from the finance that puts spotlight on the continuous growth of the significance of London (Turner 2015).

Overview of the Basel Accords 

Basel I

Basel I is defined as the set of international regulations regarding banking that have been put forward by the BCBS i.e. the Basal Committee on Bank Supervision. It has been found that this Committee has set out the minimum amount of requirement of capital for the fiscal institutions and the objective of this particular action is to minimize the risk regarding credit. Moreover, it has been found that the banking institutions that generally regulate their business globally should maintain a minimum of 8 % of capital amount depending on the percentage of the risk-weighted properties. There are three sets of regulations i.e. Basel I, II and III and all these are in together known as Basel Accords. Basel I is the first set of regulation among three.   

Basel II

It is also a particular set of banking regulations that are implemented globally, these regulations have been put forward by the BCBS, and this has leveled the global rules field along with the uniform guidelines and rules. In general, it has been found that the Basel II has expanded the regulations for the minimum amount of requirement of capital that has been developed under the Basel I. The primary differentiation between the Basel I and Basel II is the Basel II implements the risk regarding credit of assets that have been hold by the fiscal institutions for identifying the ratios of regulatory capital.   

The regulation Basel III is regarded as the comprehensive set of measures for reform that have been created by the Committee called BCBS in order to strengthen the supervision, risk management and regulation of the banking sector. The goals and objectives regarding these measures are – improvement of the ability of the banking sector for absorbing the shocks that raises due to economic stress and monetary stress. The other aims include – strengthening of the disclosure and transparency of the banks and improving the governance and the risk management.  

According to Ehrhardt and Brigham (2016), it has been found that in the era of post-financial crisis, the rates of returns fluctuated too much and was at worst declined. Therefore, in order to run profitably and successfully, the financial institutions intend to improve their rates of return and this intention results into increased risk that accompanies the pursuit leading to greater systemic risk (Halbert and Rouanet 2014). Therefore, various methods have been identified, analyzed and explored that help in improving the rates of returns.

It has been found that the rate of return on equity can be improved through five particular ways. These include – firstly by using more fiscal leverage, secondly, by increasing the margins of the profit, thirdly, by improving the turnover of the asset, fourthly, by distributing idle cash and lastly, by lowering the taxation rate. Therefore, it can be said that the essence of the return on equity captures the return that have been generated by an organization based on the capital that has been purchased by the stakeholders (Gedro et al. 2013). On the other hand, the rate of return on total assets can also be improved by dropping the costs of the assets, by increasing the total revenues of the firm and by decreasing the total expenditures. Lastly, the return on investment of a financial institution can also be developed by calculating the present return of the firm, by increasing the revenues, by diminishing the costs and by re-evaluating the expectations of the business.

Identification, Analysis and Exploration of the Tensions 

Risk and Return

It has been that the financial institution adopts and incorporates various approaches and strategies for reducing the systemic risk within the firm. The financial crisis was “perfect storm” with respect to finance that possesses multiple reasons. There are several illustrations that help in understanding the reason for which a system fails along with certain validity and point to at least three various approaches for decreasing the systemic risk of the firm in the future. According to Spence et al. (2014), the highly interrelated system has been found to fail as no one was in charge regarding spotting the risks, which might bring it down.

Therefore, it can also be said that creation of a Macro System Stabilizer along with the broad responsibility charged the spotting of the perverse incentives, market pressures and regulatory gaps for the entire fiscal system that might destabilize the particular system and takes particular stages for fixing them. The second strategy include the particular system failed due to the extroverted monetary policy and unwarranted leverage that fueled an accommodation price bubble and flare-up of risky investments took place in the asset backed securities (Sadowski and Thomas 2013).

It has been found that the low rate of interest is generally donated to the bubble and the monetary policy has several goals. Based on this it can be said that stricter guideline of leverage is required all through the entire fiscal system. Finally, the approach that helps in reducing the systemic risk of a financial institution is the crash of the system that occurs due to failure of increased inter-related fiscal organizations. It has been found that the inter-related financial corporation failed to maintain its system due to outcome of considering unwarranted risks and their failure has been found to impact the other markets and the organizations.

In other words, it can be said that the particular approach might result into policies for restraining the growth of the big interrelated fiscal organizations or break them into an expedited resolution authority for the larger firms with the aim to decrease the effect of the failure on the remaining system. Moreover, Kim and Kim (2014) stated that development of a fused regulator along with the accountability for the methodically significant fiscal institutions. In addition to these, it can be said that the contribution of the fiscal industry to the risk are mainly based on the fiscal industry (Buckland and Davis 2016). For instance, when two nations have banking system of similar magnitude, but one nation has only one bank and second one has ten similar sized banks, then it can be said that the first nation is more vulnerable.

Therefore, it can be said that every financial institution should put focus on increasing the rate of return through implementation of various methods and along with it, the systemic risk of the firm should also be reduced in order to run the organization in a better way and successfully.

Supply of funds from savers in the household sector-

In the previous past decade, the household has saved a larger proportion of disposable income. Moderation in the borrowing behavior of household sector is accompanied by turnaround in saving. Such changes have been intensified by the onset of global financial crisis and this has reduced the accumulation of debt and re allocation of saving toward the assets having lower risks such as fixed deposits. In the wake of crisis, households of United Kingdom underwent a deleveraging process from high debt to income ratios. The number of households would make default on mortgages given a high level of nominal debt. This was because of rising interest rate. The recent challenges in the housing market is mainly on supply side and constraint in supply of housing drove (Kim and Kim 2014).

Demand for funds from businesses investment in good and capital requirement-

The capital investment spending is determined by several key factors such as interest rate that affects the cost of capital. Cost of funding the investment increases if there is an increase in the interest rate. This lowers the expected rate of return on capital project. Raising of the opportunity costs is assisted due to increase in interest rate. Investment in cash by business would help in yielding better return.

Net demand for fund from government as modified by central banks-

Post the global financial crisis, central bank was forced to deploy unconventional method for encouraging lending and pumping money into the economy. The assets price and the economy was also affected by the fiscal policy of central bank, which causes a direct impact on companies and household. During 1997 to 2007, the interest rate in UK moved between a range of 3.5% to 7.5%. After the global financial crisis, the benchmark interest rate of central bank was close to zero. It was mainly to avoid economic depression. The lower level of interest rate encourages household and business to borrow for supporting the falling price, economic activity and staving off deflation. Business and households are encouraged to borrow if the yield of bonds decline, as they would be able to borrow money at cheaper rate (Sharma 2015).

Valuing bond in post global financial crisis era-

Post global financial crisis, the liquidity in certain bonds were tightened with emerging market corporate debt and widening high yield. The environment of lower interest rate created a risk of market disruption. This was in event of increase in bond yield and rates of central bank policy. Market makers underwrite Bond issues and the bonds are actively traded in the secondary market. Bonds with high yield have high level of risk and less transaction flow and it tends to be associated with number of market makers and lower market making capacity. It is suggested by commonalities in liquidity market such as bonds that risk would be quickly transmitted in the event of repricing of risk overshoots (Gedro et al. 2013).

Consequential Increase in Systemic Risk 

According to Jones et al. (2015), the financial regulations are the most important factors, as these help in running a financial institution smoothly. Moreover, it can be said that when the financial regulations become international and the same rule and regulation can be implemented globally, this makes easier for every firm to operate its business across the world. However, it has been found that with the passage of time, in the recent years, the total numbers of international regulations have increased and along with these the controls have also been increased.

Underneath this is the authenticity that the collapse of banks has critical proposition for financial systems, thus, the willingness of the governments is to bail out them. As a result, it can be said that the ‘prevention is the better than cure’ is considered as the driver (Ec.europa.eu 2017). Nowadays, the economies are very much interlocked together and are also inter-wind. Therefore, the domestic rules and regulations are not sufficient. Secondly, it has been found that the personal inducements of the bankers might not be in line with the particular members of the wider society, where they usually operate their business successfully.

Opined to Turner (2015), the specified incentives are better known as ‘agency costs’ and the reason behind this is that the goals of the senior management are to shape or design by compensating the packages and this might not get aligned with the aims and objectives of the shareholders and the investors of the particular firm. Thirdly, it has been found that in general, the banking system utilizes the fund or the money of its customers in order to develop profits. Fourthly, it has been determined that the banks usually utilize and incorporate various kinds of sophisticated goods, which are not understood for all time by every individual client (Genevaassociation.org. 2017).

As a result, this particular gap regarding the acquaintance has been found to work in good turn of the banking system or banks and thus, this help in placing the fiscal goods in the hands of the inaccurate clients of the banks. Therefore, based on this study, it can be said that the particular international regulations regarding the reduction of the systemic risk have both beneficial and non-beneficial effects on the financial institutions like banks.

Benefits and Drawbacks of Regulations Regarding the Reduction of the Systemic Risk

In addition to these, the micro and macro prudential regulations are considered as the regulations that aimed to defend the particular system as a whole, but by evading the systemic risks. Later on, these micro and macro prudential regulations become also concerned with the protection of the individual customers. However, the regulation can be of poor nature and can be concerned with the “box ticking”, in spite of being addressing the underneath matters of the substance. In addition, the regulation has also found the banks to become more innovative in the process of developing newer services and products, as this assists in finding ways regarding the regulations.

Moreover, it has been found that the governments mainly depend on the characteristics that are played by the banking system in the financial system. Furthermore, the regulations can lead to control of the behavior of the managers and this might become a challenging aspect. In addition to these, it has been found that it proceeds to look into the detail at the BCBS that is the “Basal Committee on Banking Supervision”.

This committee was outlined for creating international regulations for banking system and for harmonizing the behavior of the banks across the borders (Systemicriskcouncil.org 2017). Normally, this puts emphasis on Basel I and Basel II and these contain significant changes regarding capital requirements. It has been found that the Basel I deal with credit risk and Basel II deals with increasing the sensitivity of the minimum requirements of capital that links with all credit risk, operational risk and market risk (Hazelkorn 2014).     

Conclusion 

Finally, it can be said that the systemic risk neither be ignored, nor be eliminated and the reason behind this can be better understood from the particular definition of systemic risk. The systemic risk is developed by the help of the complex communication and the risk taking ability within the fiscal system. Thus, the main important thing is to put off the systemic crises for drastically diminishing the dimension of the fiscal system. Thus, it has been found that the nations with unsophisticated and smaller fiscal systems are not susceptible to the systemic risk. Thus, these nations might suffer if the outer world enters into the systemic crisis.

Again, it can be concluded that the existing international regulations regarding the reduction of the systemic risk are not sufficient enough for protecting the business and the operations of the financial institutions. Thus, based on the above assessment, it can be said that more international regulations regarding the reduction of the systemic risk should be incorporated in the society for better running of the financial institutions. Moreover, it can be said that the most recent concept and theory of Basel III should be implemented in the process for making the implementation and managing process more modified and updated.                                                               

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