Quantifying Systemic Risk in the European Banking Sector - Research Paper Example

Systemic risk is the ultimate threat, its sources are varied and the propagation mechanisms involve major imbalances. The financial banking domain supports the present research, a choice motivated by the imperative of identifying potential risk-carrying factors to deeply analyze their impact and raise mechanisms for efficient calibration of financial exposure levels. A major breakup within the banking sector, initially designed to serve the real economy generates severe imbalances with long-term implications for the whole financial industry and potentially destructive nature to the economic environment.

The preference for this topic is justified by its actuality and utmost importance for the European banking, financial community, and the entire economic arena. Banks’ policies and strategies, new products, technologies and services, competition policies, and the competitive environment provide space for risk’s rise. In addition, the increased level of financial integration and the globalization ties facilitate the appearance of new contagion channels, as previous banking experiences and worldwide tensions show.

Mapping the current needs of the global economy means identifying risks and quantifying their effects. A major challenge is to restore and strengthen financial and economic stability and the prerequisite for achieving this goal is the understanding of systemic risk nature and its sources in terms of structures and sizes. The first theoretical approaches to systemic risk can be traced back to the period 1929-1933, during the Great Depression; as a distinctive figure, history invokes John Maynard Keynes1, who describes the economy marked by a shock in the financial system - a sequence of events generically called contagion.

Broadly speaking, systemic risk is related to complex negative events simultaneously affecting institutions, markets, and networks. In a narrow sense, the core element of the term is the contagion from one market structure to another. Explaining the notion of systemic risk requires a clarification of concepts proceeding and succeeding in its rise: the systemic event, and respectively, the systemic crisis. A systemic event occurs when negative information about an institution spreads in the system and adversely impacts the participants.

Allen and Gale (2000) and Freixas, Parigi, and Rochet (2000) examine the risk of contagion in the shape of a domino effect, as an essential element of the systemic risk architecture. High-impact systemic events (for example, a bank collapse result of an initial shock) translate into contagion; if the shock doesn’t lead to failure, the event can be narrowed. A systemic event has two components: the shocks (idiosyncratic, systematic) and the propagation mechanisms. If idiosyncratic shocks affect individual financial institutions, systematic shocks spread across the whole economy and imbalance all financial structures at the same time.