Defining systemic risk

Systemic risk is defined as the likelihood of an event occurring at low economic levels that might lead to economic instability or outright collapse. Economic levels might be derived from commercial bank activity or market performance. The effect of market failure has been linked to systemic hazards. Moral hazard, inadequate coordination, adverse selection, information asymmetry, and behavioral bias all contribute to market failure and, as a result, are the root causes of systemic problems. Market failure will always compel people to take excessive risks, exposing the financial system to vulnerability (Basel Committee on Banking Supervision 2008). Monetary policy refers to what national central banks in various countries do to influence the amount of money and credit in the economy. Anything that affects money and credit automatically affects the interest rates and performance of the economy. Monetary policies are used by the central government to manage the flow of money in the economy which is liquidity of money (Rivlin 2009). This is aimed at improving the economic growth. Contractionary monetary policy is used to reduce inflation. Expansionary monetary policy, on the other hand, is used to lower unemployment in the economy and avoid economic recession.

Fiscal policy can be described as the Government spending and taxation that has a direct or indirect influence on the economy. The two primary types of tax policies widely used are expansionary, which stimulates market growth, and contractionary monetary policy, which aims at slowing the economic development of a country or state (Rivlin 2009).

Most countries experience difficulty in trying to measure systemic risks from liquidity (Jain et al. 2016). The reasons can be due to limited data availability, the complications are involved in purging the effects of dry liquidity ups and finally the inexistence of methods to generalize market specific funding conditions and construct aggregate measures of liquidity stress. The lack of data will make it hard to create measures of liquidity circumstances in the markets. Effects of dry liquidity-ups cannot be easily solved from generalized solvency principles and concerns.

Liquidity can be used to detect systemic risks. Financial intermediaries, which are the various financial institutions, carry the duty of maturity transformation. It is known that special allocation of resources will always lead to underdevelopment of liquidity due to asymmetric information and market failure. Asymmetry of information occurs when the information about a product is biased; the providers know more about the product than the consumers hence can influence how consumers utilize the product. Deposit insurance can help in solving this (Basel Committee on Banking Supervision 2008). Financial institutions may become overexposed to liquidity shocks in case of excessive maturity transformation occurring in their financial statements like the balance sheet. A better way to cushion the economy against liquidity risks is to call for more regulations to discourage funding in liquidity cases.

Not all institutions can be classified as possible sources of systemic risks. The key identifying factors are:

a) Size; the higher the sales in business means the increase in volatility hence systemic risks.

b) Inter-connectedness; related markets may expose the possibility of risks being transferred from one market to the other or risks being transferred to one market at the expense of the other.

c) Substitutability; Products that are easily substituted in the market can lead to consumer hazard morals. This can affect the trading of such products in the market hence possibility of the growth of systemic risks.

d) Availability of services rendered also has an impact on systemic risks. A market with more services and of higher quality will mean a healthy flow of money in the economy.

The central banks, financial institutions, markets, and products all pose a risk to the growth of systemic risks in one way or the other though they may not exhibit all the outlined characteristics in one unit.

The primary areas of vulnerability in our analysis will be the central federal regulatory, financial institutions, markets, and products. More efforts should be aimed at increasing resilience in the financial sector in turn promoting the financial stability of the economy. This will help in shocking the economy from systemic risks (Andian et al. 2013).

Roles of Central Banks, Financial Institutions, Markets, And Products In Systemic Risks Elevation

Central banks

Central banks are the backbone of the financial system in their respective countries. They have to identify extensive systemic vulnerabilities and formulate ways to deal with them, provide financial stability through offering emergency liquidity assistance to illiquid institutions and protect the global financial system from failure.

High liquidity creation in the part of central banks may increase failure probability in the economy (Fungacova et al. 2015).

Regulation alone is not sufficient to curb the elevation of systemic risks and create financial stability. Contagion always occurs when the distress experienced in one financial institution infects others in the system and leads to a systemic crisis. An example of this is the Great Recession of 2007 to 2009.

The process of adjusting to the aftermath of rapid asset price growth and low-risk premiums always takes time. This period may be characterized by economic sabotages in various countries and prove difficult to manage if policies are not adhered to ensure full adjustment. Central banks should be the ones to oversee this. Central banks are well placed to recognize and prioritize risks. They can work within frameworks that maps and traces potential weakness within the chain.

Financial institutions

Banking panics. The new fears have been associated with depositors withdrawing more money than they need for consumption. This can be as a result of seeing other people taking money out in bank run cases. However, this has been recently not been the trend.

Complication of the banking system also plays a role in the systemic risk. A high number of the commercial banks have been known to increase their exposure to risks. This is because an increase in exposure promises greater rewards. Financial institutions also have a role in the elevation of systemic risks. Weak corporate mechanisms in the banks have always been associated with the financial crisis (Marcinkowska 2012). They are the main contributors to the financial crisis. So as to regain stability profound, severe changes have to be made. The causes of banks increasing the risk to an elevation of systemic risks can be the reasons discussed below.

Loss of public confidence in financial institutions and the entire banking system is a setback to the economic stability of a country. This is vital in ensuring the financial system and economy of a country is stable. The role, tasks, and responsibilities of the board may expose a financial institution to risks. Their size without forgetting the responsibilities should also be analyzed. Some may be incompetent and decisive in making laws that expose the economy to elevation of systemic risks

The exposure of banks to excessive risks also leads to elevation of risks. The exposure should be limited to some extent so as to save these financial institutions from the crisis. Lack of systems to evaluate the executives in the banks and their incentive pays may also harm the economy. The roles of the executive should be clearly stipulated, and the objectives clearly stated to direct their actions. Transparency in the bank managerial system is required. The integrity of the managers should be put into question to force them to act professionally. The ownership structure and objectives of the financial institutions should be reviewed. The role of investors and their motives should also be checked.

An increase in savings about real investment opportunities enhances the elevation of systemic risks. More money is withdrawn from the economy regarding savings, and little is left to circulate. This may lead to inflation hence increase in systemic risks in the economy.

Markets

Declining prices of assets can also lead to the elevation of systemic risks. The property in reference can be houses or stocks. The change in prices of such assets can lead to the banking crisis in the economy. These crises, in turn, may trigger systemic risks. The easier it is to access loans for real estate development the more the price depreciation of houses will be.

Products

Products created in this world are aimed at satisfying consumer needs. People tend to produce more products that fetch high returns so as to earn more from the profits. These products will mostly be traded in markets where regulation constraints are fewer and favorable taxation exists. This will starve economies that are not supportive of the products hence an imbalance in the circulation of money in such savings. Inconsistent flow of money in the economy will, in turn, lead to inflation.

Rules and Regulations in Different Economic Sectors to Ease Systemic Risks

The main agenda for reforms policies are to deal with critical dimensions that are regulatory policies, regulatory structure, and crisis management.

Regulatory changes are incentives and constraints designed to affect the level and concentration of risk-taking across the financial system in the economy. They are economic analogs to curb actions that cushion the economy from adverse effects of systemic risks. Regulatory structures are responsibilities for setting and enforcing the set rules and regulations.

Crisis management explains when and how to intervene. The expectations for interventions are also covered under crisis management.

Central banks

Central banks are close affiliates to governments in each and every country in the management and control of the economy. They are the lenders of last resort to all financial institutions in an economy and advisors to the government in economy matters.

The role of central banks all over the world has been significantly up surged. They have the mandate to tame inflation, and this has led to the need for central banks independence and protection from political interference (Andian et al. 2013). To prevent recurrent systemic risks from occurring, these central banks should:

Ensure the models in use are favoring financial regulations than policies. Most models are useful in setting monetary policies rather than regulatory policies.

Bank regulators empowerment will also help. Bank regulators will always provide first-hand information from experience since they operate on the ground knowing what actions can help, unlike monetary economists who mostly are experienced in formulating monetary policies.

The central regulator should always go with reality. Therefore the central regulator should not only set policies and leave other parties to execute them, but it should also step in to detect if the grounds persons are exercising any malpractices.

The central bank should work in cooperation with other regulators. The sharing of information, strategies, and ideas will help tackle problems.

The objectives of financial institutions should be monitored and legislations put in place to be implemented. This will improve integrity in the financial institution’s structure hence reduce exposure to risks due to owners greed that may lead to the elevation of systemic risks.

Financial institutions

Financial institutions play a significant role in offsetting systemic risks after the central banks in each and every commercial set ups. Embracing diversity among other important financial institutions will help also. One-size-fits-all regulation will not work. This forces the need to bring different parties to the table before formulating policies.

The first solution to bank panics has been to offer deposit insurance and other guarantees to customers so as to boost their confidence in the banking industry. Bank panics can arise due to prospects for the future some of which may be lies. Proper communication mechanisms between financial institutions and their clients should be prioritized. Good communication will make consumers aware of the happenings in their institution hence ability to make appropriate and well-informed decisions (Board of Governors of the Federal Reserve System 2017).

Bank complexity can help in reducing exposure of banks to risks that can lead to a systemic crisis in the economy, adding more complexity to the banking systems will help lower bank exposure to risks hence reduced the probability of elevation of systemic risks. The managing board of a financial institution plays a significant role in deciding the day to day activities of the organization and policies that guide them. Their work should be assessed periodically and continuously to ensure no malicious practices are being carried.

The executive board of the financial institution should be monitored. The need to evaluate the executive is critical for the well-functioning of the financial institution, hence reduced exposure to risks that may be of harm rather than the economic benefits to the organization and the economy to a great. Strengthening the economic foundation of the main investment firms and commercial banks ensures the reduction in systemic risks. Increase in the quality of public disclosure limits risks and ensures the public is aware of how the economy operates. Increasing equity capital into many financial institutions and reducing liquidity pressure in markets reduces systemic risks (Board of Governors of the Federal Reserve System 2017).

Market

Rules and regulations set up via markets should always aim at keeping the values and prices of assets and services in check. Balance in the forces of demand and supply will ensure this. Market failure will always be as a result of the risks accrued from the imbalance of these two forces.

As mentioned earlier, the value of assets in the economy will always dictate the growth of the economy. The falling prices of assets such as real estates can be dealt with by ensuring the monetary policy is stable and reliable. Interest rates can be capped higher to ensure loans are relatively hard to access. This will make it expensive for real estate developers to lower their prices hence reduce the possibility of elevating systemic risks. The restriction of real estate loans in some regions and increasing of property transfer taxes can also help in reducing the elevation of systemic risks due to decline in asset prices.

Policies and regulations should be put in place in economies that are viewed not to favor the trade of particular goods and products that fetch higher returns. These policies should be favorable for the trading of such products hence cushioning the starving of such markets from the benefits of these commodities. This will ensure the flow of finances in these markets hence the uniform movement of economies between different economies. One economy will not be deteriorated due to finances being drawn to other economies.

Products

The public will always respond to the utilization of goods according to the utility possessed by the product. Products that fully satisfy the needs of consumers will be consumed at a higher rate compared to their counterparts.

Public trust is the better way of ensuring the success of the banking system in states or countries. Corporate governance and practices have to be integral in gaining and maintaining public confidence. Trust is a fundamental prerequisite for a properly functioning banking system. The savings made by people should be comparatively equal to investment opportunities. This will ensure the money withdrawn from the economy regarding savings can be reversed back into the economy regarding savings hence a continuous flow of money in the economy.

Rapid asset price growth and low-risk premium should always be dealt with systematically and with limits within the law. This will ensure economies do not experience recurrent problems from such problems that can result in inflation (Bank for International Settlements).

The financial structure of the economy can also be strengthened to provide a cushion against the repulsions of systemic risks. The increase in resources held by financial institutions against the risk of default by clients may reduce vulnerability.

Economic Changes to Reduce Systemic Risks

Economic triggers can be introduced into the economy to offset systemic risks. The infrastructure and liquidity sectors of the economy are the main areas of the target in sanctions aimed at the economy in general (Basel Committee on Banking Supervision 2008).

Some changes in the infrastructure that can be taken to improve the financial systems ability to manage consequences of failures by major financial institutions that may lead to systemic risks include;

a. The establishment of a central clearing house for credit and default swaps. This institution will reduce work burden on financial institutions.

b. The use of bilateral and multi-lateral netting to reduce levels of outstanding contracts in the economy.

c. Establishment of protocols to be adhered to in managing defaults in existing and future credit derivative contracts.

d. Concentrating on targets to achieve greater automation of settlement and trading prospects.

The regulations made should also be designed in a manner that they aim at curbing systemic financial crises. Poorly designed policies will worsen the crisis. The objective of these policies should always be to negate financial crises. This juncture will need a deep review of problems that the market can solve on their own and those that the market cannot solve on their own. Forcing policies into place, so as to solve problems that could easily be solved be by the market, can be at a significant disadvantage to the economy hence increase exposure to systemic risks (Basel Committee on Banking Supervision 2008).

Liquidity and Systemic Risks

Central banks are a lender of last resort in each and every country not only do they identify system-wide risks. Performing this role is not enough to prevent shocks of systemic risks but can neutralize secondary repercussions arising from the same systemic risks(Fungacova et al. 2015).

Two principles that aid in supporting liquidity in markets by central banks in most countries around the world are:

a. Reducing moral hazards through lending’s to support liquidity.

b. The interventions made by central banks should be targeted, graduated, well designed and created to prevent markets distortions in the economy.

By limiting liquidity, systemic risks may be reduced. Liquidity is the problem arising when too much of the assets hold by a firm are not readily convertible into cash (Zacks Investment). Limiting liquidity may also help in reducing the chances of elevating systemic risks. This can be done by;

a) Diversification of assets. This will enable institutions to sell assets right away hence can settle debts without cases of bad debts or debt crises as experienced in Greece.

b) The timing of investments is also important. Short-term investments keep liquidity risk low compared to long-term investments that may cause imbalances in finances of an institution.

c) The minimization of debt enables financial institutions to lower liquidity risks as it ensures stability in the financial systems of the institution.

In solving the most financial crisis, new types of liquidity facilities are demanded. Longer terms of solutions, broader pools of eligible collaterals and a broad range of counterparties should be put to use to offset the balance and bring about an efficient economic system (Fungacova et al. 2015).

Conclusion

Systemic risks are always a risk to the economy of a country. An influx in the systemic risks of a country will always have an impact on the Gross Domestic Income in the economy. The main objective of reforms in the regulatory frameworks is to mitigate fragility of the system. Making shock absorbers of systemic risks stronger is the best way of ensuring that failures are handled. Making the regulatory system adapt to quick actions in addressing vulnerabilities is important. Lastly, integrity on the part of people running these institutions is the key role to their success or failure.

Works Cited

Andian, Tobias, et al. “Financial And Economics Discussion Theories; Financial Stability Monitorinbgf”. Referal Reserve Board, 2013, http://.federalreserve.gov/pubs/feds/2013/201321/201321pap.pdf.

Basel Committee on Banking Supervision, ”Principles Of Sound Liquidity Risk Management And Supervision”. Www.Bis.Org/Publ, 2008, http://bis.org/publ/bcbs144.pdf.

Board of Governors of the Federal Reserve System, ”Federal Open Market Committee”. Www.Federalreserve.Gov, 2017, https://www.federalreserve.gov/monetarypolicy/fomc.htm.

Fungacova, Zuzana, et al. ”IMF Working Paper; High Liquidity Creation And Bank Failures”. Www.Imf.Org/External/Pubs, 2015, http://imf.org/external/pubs/ft/wp/2015/wp15103.pdf.

Jain, Pankaj, et al. ”Does High-Frequency Trading Increase Systemic Risks”. Www.Clsbluesky.Law.Columbia.Edu, 2016, from http://clsbluesky.law.columbia.edu/2016/10/28/does-high-frequency-trading-increase-systemic-risk.

Marcinkowska, Monica. ”Corporate Governance In Banks; Problems And Remedies”. Www.Is.Muni.Cz/Do/Econ, 2012, https://is.muni.cz/do/econ/soubory/aktivity/fai/33967799/FAI_issue2012_02_Marcinkowska.pdf.

Rivlin, Alice. ”Systemic Risks And The Role Of The Federal Reserve”. Www.Fic.Wharton.Upenn.Edu, 2009, http://fic.wharton.upenn.edu/fic/Policy%20page/Rivlin-Final-TF-Correction-2.pdf.

Zacks Investment Research, ”How To Avoid Liquidity Risks”. Finance.Zacks.Com, 2017, http://finance.zacks.com/avoid-liquidity-risks-8881.html.