Kasinomics

The need for systemic risk

To speak about systemic risks only makes sense when analyzing a large system, such as the international financial markets. The financial markets are the quintessential traders of risk, because risks from investments, macro- and micro-economic policy, technological innovation and behaviour of market participants is constantly assessed and priced.

The existence of risk is a necessary feature of markets. The existence of systemic risk is a necessary feature of highly integrated markets. Both on the national and the international level, there is always the potential for a system-wide collapse of markets because a large number of market participants reassess their risk profiles and act accordingly, for instance by disinvesting from certain asset classes which then leads to decreased liquidity in some parts of the markets.

Market participants should be aware of the existence of systemic risk and price in in their investor decisions. There are several reasons why this is difficult:

• Firstly, it is not easy to locate the first domino-stone which brings a market to a collapse, even if all market participants agree that a collapse is immanent.
• Secondly, it is not easy to price the effects of market collapse on individual asset classes.
• Thirdly, it is very difficult to predict the political economy of market collapses and the bail-out attempts by policy-makers.

Given these difficulties, there is considerable possiblity that market attempts fail to correctly price systemic risk, even if their intentions are well. Also, given these difficulties, it is quite likely that regulators will not necessarily ex-ante be able to predict the right measures to avoid systemic risk.

Another issue needs to be kept in mind: financial products with the highest yields are at the edge of financial regulation. Financial institutions are most competitive where regulation is contradictory, available for regulatory arbitrage or simply not spelled out yet. Therefore most market participants, especially banks, do not mind that systemic risk exists. Systemic risk allows them to make a business.

In essence: systemic risk is not a negative externality that needs to be re-internalized through regulation, as Kern, Eatwell and Dhumale suggest. Systemic risk should be seen as the break up of network-communication inside a system and regulation needs to ensure that communication channels are promptly restored after a market collapse.

See also

• Intergovernmentalism in Financial Regulation
• Global Financial Governance - Definitions by Alexander, Eatwell and Dhumale
• Alexander, Dhumale, Eatwell: “Global Governance of Financial Systems”
• Systemic Risk - Discussion by Alexander, Eatwell, Dhumale
• Thoughts on transnational networks of private international bodies in the financial architecture
• Project: Mapping the Financial Governance
• Trilemma in financial supervision - Schoenmaker, Oosterloo
• Financial stability - a public good?
• Eatwell, Taylor - Global Finance at Risk
• Corporate Governance and International Standards - Paper by Kern Alexander and Rahul Dhumale