What is systemic risk, and do bank regulators retard or contribute to it?

• Author: Kaufman, George G.

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). These definitions emphasize correlation with causation, and they require close and direct connections among institutions or markets. When the first domino falls, it falls on others, causing them to fall and in turn to knock down others in a chain or "knock-on" reaction. Governor E. A. J. George of the Bank of England has described this effect as occurring "through the direct financial exposures which tie firms together like mountaineers, so that if one falls off the rock face others are pulled off too" (1998, 6). For banks, this effect may occur if Bank A, for whatever reason, defaults on a loan, deposit, or other payment to Bank B, thereby producing a loss greater than B's capital and forcing it to default on payment to Bank C, thereby producing a loss greater than C's capital, and so on down the chain (Crockett 1997). Banks, especially within a country, tend to be connected closely through interbank deposits and loans. Note that in this second definition, unlike in the first macroshock definition, only one bank need be exposed in direct causation to the initial shock. All other banks along the transmission chain may be unexposed to this shock. The initial bank failure sets off the chain or knock-on reaction.

The smaller a bank's capital-asset ratio--the more leveraged it is--the more likely it is that it both will be driven into insolvency by insolvencies of banks located earlier on the transmission chain and will transmit losses to banks located later on the chain. What makes direct-causation systemic risk in financial sectors particularly frightening to many is both the lightning speed with which it occurs and the belief that it can affect economically solvent (innocent) as well as economically insolvent (guilty) parties, so there is scarcely any way to protect against its damaging effects.

A third definition of systemic risk also focuses on spillover from an initial exogenous external shock, but it does not involve direct causation and depends on weaker and more indirect connections. It emphasizes similarities in third-party risk exposures among the units involved. When one unit experiences adverse effects from a shock--say, the failure of a large financial or nonfinancial firm--that generates severe losses, uncertainty is created about the values of other units potentially also subject to adverse effects from the same shock. To minimize additional losses, market participants will examine other units, such as banks, in which they have economic interests to see whether and to what extent they are at risk. The more similar the risk-exposure profile to that of the initial unit economically, politically, or otherwise, the greater is the probability of loss, and the more likely it is that participants will withdraw funds as soon as possible. This response may induce liquidity problems and even more fundamental solvency problems. This pattern may be referred to as a "common shock" or "reassessment shock" effect and represents correlation without direct causation (indirect causation).

Because information either on the causes or the magnitude of the initial shock or on the risk exposures of each unit potentially at risk is not generally available immediately or accurately and is not without cost, and because analysis of the information is not immediate or free, participants generally require time and resources to sort out the identities of the other units at risk and the magnitudes of any potential losses. Moreover, in banking, as credit markets deteriorate, the quality of private and public information available also deteriorates as the cost of accurate information increases and as uncertainty increases further. Because many of the participants are risk averse and would rather be safe than sorry, they quickly will transfer funds, at least temporarily during the period of confusion and sorting out, to well-recognized safe or at least safer units without waiting for the final analysis. In addition, in periods of great uncertainty and stress, market participants tend increasingly to make their portfolio adjustments in quantities (runs) rather than in prices (interest rates). (1) That is, at least temporarily, they will not lend at almost any rate. Thus, there is likely to be an immediate flight or run to quality away from all units that appear potentially at risk, regardless of whether further and more complete analysis might identify them ex post as having similar exposures that actually put them at risk of insolvency. At this stage, common-shock contagion appears indiscriminate, potentially affecting more or less the entire universe and reflecting a general loss of confidence in all units. Solvent parties are not differentiated from insolvent. Because these runs are concurrent and widespread, such behavior by investors is often referred to as "herding" behavior.

The runs are likely to exert strong downward pressure on the prices (upward pressures on interest rates) of the securities of affected financial institutions and markets. Any resulting liquidity problems are likely to spill over temporarily to banks not directly affected by the initial shock. Thus, the initial domino does not fall directly on other dominos, but its fall causes players to examine nearby dominos to see whether they are subject to the same destabilizing forces that caused the initial domino to fall. Broad contagion is likely to occur during such sorting-out or reassessment periods.

At a later date, after the sorting-out process is complete, some or all of these flows affecting solvent banks may be corrected or reversed. Nevertheless, during the sorting-out period, the fire sale-driven changes in both financial quantities (flows) and prices (interest rates) are likely to overshoot their ultimate equilibrium levels because of an uncertainty...