Factors Rapid Spread Systemic Risk in a Financial System - Essay Example

Introduction ‘Following the abrupt increase in home prices in the 2004-2006 period many financial s increased their holding of mortgages and mortgage-backed securities, whose performance was based on the timely mortgage payments made by home owners. Some financial institutions (especially commercial banks and saving institutions) aggressively attempted to expand their mortgage in order to capitalize on the strong housing market’ (Madura 2012, p17 ‘see this details of that book below’) This essay examines important elements and components of systematic risk in finance adnd how it spreads through the financial system. It will involve a critique of the subject and an examination of important elements and aspects of systematic risks and how it occurs in the finance sector. The analysis will focus on the sub-prime mortgage financial crises of 2007 – 2009 as a yardstick in describing systematic risk. In attaining the aim of the essay, the following objectives will be examined: 1. A critical review of the concept of systematic risk and its definitions. 2. An examination of how systematic risk spreads through a financial system. 3. An analysis of the factors that affect the rapidity and extent of the spread of systematic risk in a financial system. Definition of Systematic Risk “Systematic financial risk refers to an event (shock ) which triggers a loss of economic value or confidence in, and attendant increases in uncertainty about a substantial portion of the financial system that is large enough to, in all probability have an adverse effect on the real economy” (De Nicolo and Kwast, 2002: 4). Another definition put forward by Billio et al states that “any set of circumstances that threatens the stability of or public confidence in the financial system” (2010) This definition of systematic risk is a macroeconomic view of the phenomenon. It effectively means that systematic risk is any macroeconomic or pervasive financial risk that has a significant effect on the wider economy. Thus, the definition encompasses any event or major situation that has an adverse effect on the financial system of a given economy. Examples of such systematic risks are the increases in inflation or an unexpected change in the prices of crude oil. Another example is the subprime mortgage financial crises that hit the United States between 2007 and 2009. These changes will inevitably affect the financial sector of a given country and it can lead to issues that can cause the returns on investments on all assets in the economy to be affected adversely. Another facade of examining systematic risk is to view it from the position of assets in a given corporate entity. Smart and Megginson identify that “systematic risks simultaneously affect many different assets, whereas unsystematic risks affect just a few securities [or assets] at a time.” (2008: 225). This definition creates a distinction between systematic and unsystematic risks. The main difference is that systematic risks affect all the assets that a given company holds at the same time. It is a pervasive financial risk that affects all the assets a firm holds. This is different from unsystematic risk which is unique to a specific class of assets. This implies that systematic risk can be eliminated by investing in different assets and balancing the financial risks of the different asset classes. This is known as diversification. Systematic risk is unique by the fact that it cannot be controlled by diversification. It involves financial risks that are pervasive on the financial market (Smart and Megginson, 2008). That is the reason why systematic risk is described as market risk. This is because it is an inherent risk that affects all assets in the economy. Systematic risks can only be controlled by investing in risk-free securities like government bonds and treasury bills (Lee, 2006). This is because the risk-free securities are uninfluenced by the things that occurs in the markets. An example is the case of a treasury bill which is a perfect example of a risk-free security for a small company. A treasury bills interest rate is fixed and cannot be changed by the externalities on the market. Due to this, it could be considered as a solution to the problem of systematic risks. The Spread of Systematic Risk in a Financial System Madura identifies that systematic risk is the spread of finacnial problems among financial institutions and among financial markets that could cause a collapse in financial institutions (2012). Figure 1: Basic Diagram of the Development of Financial Risk to a Systematic Risk Alexander et al identify that banks have an incentive to underprice the actual rate of financial risks (2005). This is because such situations allow them to get more opportunities to present a more favorable picture of their operations and activities. This gives banks and other financial institutions more room for activities that might overstate their assets and understate their liabilities. When banks value their assets and liabilities wrongly, the capital markets could come under serious financial problems (Kolb, 2010). This leads to subprime financial crises and various stakeholders cannot honor their obligations and their fundamental bills. Due to this, the financial problem at hand spreads through the major financial institutions. Since the financial market is interconnected with financial intermediaries like banks, insurance companies and other entities, the risk spreads through the system and it affects individual assets in the economy. According to Murphy (2012), systematic risk can be spread through the financial systems through one of four circumstances. These circumstances are as a result of a firm, person, government, financial utility or policy which might cause the financial system to become destabilized. They include: 1. Failures of one unit of the financial sector which causes other failures (Domino Effect): Under the Domino Effect, one entity in the financial sector makes a mistake and other different financial entities in the sector connected to it goes into financial crises. This causes the financial risk to spread from that entity to other entities. Basically, the 2007 subprime mortgage crises could be linked to this. 2. Information flow about distress in one class of assets provide signals that other assets are also distressed (Contagion): Under this mode of the spread of systematic risk, news of a distressed class of assets provides indications that there are major problems and suspicions about a connected class of assets. This causes major problems on the financial markets which affects financial intermediaries and their securities or assets. With this situation, investor confidence and valuations could change significantly and this can cause a major disruption in the financial sector and a systematic risk could be triggered. This leads to major financial crises that affects assets in a given economy. 3. Fire/Panic Sales During Decline: In a situation whereby there is a major decline in the value of a class of assets, the obvious fall in value and risks that are identified by consumers causes consumers to sell their assets. This triggers sharp fluctuations in the prices of financial securities and assets and this could cause major disruptions that can allow systematic risk to be spread in the financial markets. 4. The absence of a given firm, person, government or financial intermediary can force the termination of an essential service which is called a critical function: In other words, the collapse of a major entity in the financial markets could cause a major financial problem which could lead to major changes in the financial sector. This could lead to systematic risk because the closure of such an entity would inevitably cause major lapses in assets and securities which could lead to major risks and uncertainties that can influence the financial sector of a given economy. Thus, it can be said that systematic financial risk occur when there are major problems in a given economy or financial sector of a nation. These problems causes a chain reaction which affects other intermediaries in the financial sector. In other cases, systematic risk can result from information about a given class of asset which gives clues of wrongful valuation of other assets which triggers panic and panic sales which disrupts the economy. Also, the absence or closure of a crucial financial sector could lead to the growth in systematic risks. In all these situations, it is conclusive that systematic risk comes about when there is a disruption in the financial markets as a result of problems and issues which relate to major financial institutions or connected financial institutions. This can affect the operation and health of individual assets in a given economy. In order to examine the illustration of this situation, the classical case of systematic risks can be evaluated to provide a fair idea of the 2007/08 subprime financial crises. These crises seem to have all the four elements of systematic risk described above. Figure 2: Financial Sector and Flow of Investments Case Study: 2007 Subprime Crises The financial system above indicates that most people in the financial system invest their surplus funds into financial intermediaries like commercial banks and other institutions whilst others invest in securities and shares. Insurance companies also represent a major group of stakeholders in the financial sectors whilst mutual funds represent an opportunity for investments into shares and other instruments. Employees and employers make deductions into pension funds. These financial intermediaries invest their monies in various ventures. This creates the financial system. According to Madura (2012), in the period between 2004 and 2006, abrupt increases in home prices caused financial institutions to increase their holdings in mortgages. In other words, they provided a lot of mortgage-backed securities. Financial intermediaries invested aggressively and applied liberal standards in granting mortgages. In some cases, these financial institutions failed to verify clients creditworthiness. Between 2007 and 2009, there was an increase in the numbers of mortgage defaults. This is because many people who got mortgages were not in a position to pay them. Home prices plummeted and the values of collateral was less than the mortgages were. This shows that the valuations were faulty. In January 2009, as many as 10% of all home owners were behind on mortgage payments. There were serious losses in mortgages. Systematic Risks and How they Manifested 1. Many financial institutions that originated the mortgages prior to the crises sold them to financial institutions like commercial banks, mutual funds and insurance companies). Thus, the financial intermediaries posted major losses. This caused a domino effect which hit other smaller intermediaries that were connected to them. 2. Financial institutions that invested in derivative services representing the payments on mortgage were exposed to the crises (Contagion). This is because it was apparent that their assets and securities were overvalued in their books and there was the need to deal with this issue by revaluing their assets to show the actual values. 3. Fire/Panic Sales that came up as a result of the fall in prices of homes caused the value to fall further. This is because there were numerous sellers and a few buyers. Naturally, the prices of homes fell further. 4. Some financial institutions especially security firms relied heavily on short-term debts to finance their operations. They used their mortgage-backed services as collateral. However, when the prices of mortgage-backed securities fell further, major securities firms like Bear Stearns and Lehman Brothers could not acquire more loans so they folded up. These financial intermediaries were providing critical functions for some companies and this led to major systematic risks for the economy. Together, all these factors defined the financial crises of the subprime financial crises of 2007 and 2009. They caused major disruptions in the economic sector and destroyed the financial terrain of the United States. Factors that Affect The Extent of the spread of Systematic Risk In my opinion, the factors that causes the fast spread of systematic risk include: 1. Lack of regulations which leads to the falsification of information and the use of negative methods to conduct business 2. Limited accounting standards and reporting requirements 3. Presence of Loan Issuer Diligence 4. Lack of bailouts to assist critical financial institutions as and when they need them. 5. Quick spread of information about sudden changes in the markets. 6. Complexity of financial instruments 7. The extent of connection between a troubled sector and other financial institutions in the nation. 8. Financial intermediaries approach to contain risks with other financial players. 9. Risk monitoring in the sector 10. Credit market resilience As identified by Alexander et al (2005), most banks would want to come up with information that would favor them and favor their position. Due to that, there is the need for regulations on how they should conduct business and carry out their activities. Thus, in a country where there are standard laws on how to report and conduct business, the influence of systematic risk is likely to be lower than a nation that does not have such standards. Also, the standardization of accounting rules is important in determining whether systematic risk will be fast and pervasive or limited and slow. In the situation where there are standardized accounting rules for reporting, systematic risk is likely to be controlled to a large extent. Where there are no such rules, people would take advantage of the situation and report things that would create problems. The presence of loan issue diligence would reduce systematic risk (Corrigan et al, 2008). This is because The issue of loans without due diligence is a major source of financial problems in a given economy. Thus, where there are checks, systematic risk is likely to be avoided. The availability of bailout options is likely to determine the speed at which systematic risks would move. This is because where there is a bailout, banks can always come out of their financial challenges and remain productive. If there are none, financial institutions will collapse quickly and the domino effect would be spurred on. For instance, the US Treasury injected over $700 billion stimulus which prevented the collapse of the US economy (Madura, 2012). It is also apparent that the rate of flow of information would determine whether systematic risk will affect an economy quickly or not. In an economy where there are formal structures of reporting incidents in an economy, there is likely to be less panic when assets are valued differently. This is because where there is the opportunities for authorities to give official accounts to all and sundry, panic would be checked. If there is no such arrangement, panic can lead to the quick spread of systematic risk. The complexity of financial instruments affected by financial challenges will determine the scope of the systematic risk. In cases of fairly simple financial influence, the contagion and domino effects will be limited. However, if they are complicated, the systematic risk will spread relatively faster. Also, the extent of connection of an affected sector with different parts of the financial sector will determine the speed at which a given systematic risk situation would affect the economy. Also, the approach to monitoring and containing risk used by the financial sector of the country will determine how fast the economy is affected by the systematic risk (Kritzman and Li, 2010). Also, the monitoring of risk is important in determining the speed with which a given systematic risk would affect an economy. After the 2007 subprime mortgage crisis, the US government set up an oversight committee to monitor the economy and detect financial systematic risks and deal with them (Madura, 2012). It would be less faster for a systematic risk to hit the economy now than it was before the oversight committee was formed. Conclusions Systematic risk refers to risks circumstances that threatens the publics confidence in the financial sector of a nation. The domino effects, the contagion factor, rate of panic and the close down of critical functioning entities determine the flow of systematic risk. The rate or speed of a systematic risk affecting an economy would vary depending on the presence of regulations, diligence standards, availability of bailouts, spread of information and the monitoring of the economy by authorities. References Alexander, K., Dhumale, R. and Eatwell, J. (2005) Global Governance of Financial Systems Oxford: Oxford University Press. Billio, M., Getmansky, M., Lo, A. W and Pelizzon, L. (2010) “Econometric measures of systemic risk in the finance and insurance sectors,” NBER Working Paper 16223, NBER. Corrigan, G. E., Flint, D. J. and Antoncic, C. (2008) “Containing Systematic Risk: Road to Reforms” The Report of CRMG III De Nicolo, G. and Kwast, M. L. (2002) Systematic Risk and Financial Consolidation: Are they Related? Issues 2002 – 2055 New York: IMF Publications. Kolb, R. (2010) Lessons from Financial Crises: Causes, Consequences and Economic Future Hoboken, NJ: John Wiley & Sons. Kritzman, M., and Li, Y. (2010) “Skulls, Financial Turbulence, and Risk Management,” Financial Analysts Journal, 66(5), 30–41. Lee, C. F. (2006) Encyclopedia of Finance London: Springer. Madura, J. (2012) Financial Institutions and Markets Mason, OH: Cengage Murphy, E. V. (2012) “What is Systematic Risk, How Does it Apply to Recent JP Morgan Losses?” Congressional Research Service May 24, 2012. Smart, S. and Megginson, W. L. (2008) Corporate Finance Mason, OH: Cengage Read More