(PDF) The Concept of Systemic Risk

Systematic Risk

Table of Contents
INTRODUCTION...........................................................................................................................1
MAIN BODY...................................................................................................................................1
TASK 1............................................................................................................................................1
Briefly explain the project or system...........................................................................................1
TASK 2............................................................................................................................................2
Different view of scholars............................................................................................................2
TASK 3............................................................................................................................................3
Concept of Systemic Risk............................................................................................................3
Global Financial Crisis (GFC) 2008............................................................................................4
TASK 4............................................................................................................................................6
CONCLUSTION.............................................................................................................................7
REFERENCE...................................................................................................................................8

INTRODUCTION
Systematic risk is one which is inbuilt in the entire market and is difficult to be prevented
or unavoidable to a certain extent. It is also called undiversified or market risk. These affect the
whole market segment not specific industry or entity. It is not predictable and not possible to
avoid, management have to develop different types of strategies which help the organisation to
overcome from such possibilities of hazard. With the help of Risk Management companies try to
reduce or minimise by use of various tools. Another type of it relates to Systemic which is an
event that triggers instability or collapse of entire industry or economy. It is the major contributor
in the financial crisis of 2008 and most of the organisation consider it as 'too big fail'. In the
context of given report, has been taken into consideration with its main focus on Lehman
Brothers that led to Global Financial Crisis of 2008 and its effect on Australian Economy.
Systemic risk not be confused with systematic risk because it will include the whole financial
system. This report include the system, systemic risk, cascade risk where business have to
manage risk that occur in the organisation or affect the whole industry or economy. It include the
current trends in theory and it's application of risk management. In addition, it include the role of
leadership to mange project and associated with best practices.
MAIN BODY
TASK 1
Briefly explain the project or system
In the 2008 financial crises Lehman Brothers collapse became one of the biggest failure
of history. Company provide huge amount loan to the people who are not able to take sub-prime
loan because of their financial status. But Lehman Brothers provide huge number of mortgage
loan to the public and after this number of defaulters will increase. At that point, company going
to bankrupt which affect the economy most (Acharya and et.al., 2017). Between 2004 to 2006,
capital market increase by 56% because of Lehman's real estate business. It will cause to become
fastest growing investment banking and assets management business. Due to failure to comply
with policies of government regarding credit facilities also led to the demise of Lehman Brothers
as an investment Bank as well as the induction of Financial Crisis. It is reported that company
have $19.3 billion revenue and $4.2 billion net income in 2007. 2008 financial crises is one of
the worst economic disaster after 1929 Great depression period. Federal Reserve and Treasury
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Department try to prevent this through various practices. It was started from 2006 when banks
allow people to take out 100% loan value to their homes . Most of the people blame Community
Reinvestment Act where it will pushed banks to invest in sub-prime area. After this, it will take
drastic turn in the banking sector because of several issues such as defaulters on loan,
unsustainable sub-prime mortgage and housing market began to crash. Because of the defaulters,
Lehman Brother become bankrupt and it affect the economy at huge level. Stock price of
Lehman drastically reduce and almost 77% investors doubt were grow and CEO of the company
have to sell their assets management units (Bisias and et.al., 2012). After fallout from Lehman
Brothers other factors also affected and it resulted, over 6 million jobs were lost and10%
unemployment rose. After bankruptcy of Lehman Brothers it will become synonymous of
financial crisis 2008.
TASK 2
Different view of scholars
According to Acemoglu, Ozdaglar and Tahbaz-Salehi (2015), risk management
associated with the market where individual or industries linked with various accidents. It
include the market risk where organisation try to overcome the risk by use of different strategies.
Risk can be occur because of legal liability, financial uncertainty, management errors, accidents
in the workplace or because of the product they produce and natural disaster. To overcome these
causes, individual as well as industry need to take necessary actions and manage the risk. As per
Dionne (2013), Risk management in banks become hot topic after 2008 financial crises. For the
avoidance of risk, management need to develop sophisticated strategies which the banks to meet
their goals. That further helps in avoiding major crises by following various practices. Also
Bessis (2015) suggests that Risk Management can also be used as a measure to control the
exposure of risk within organisations and in the economy as a whole to prevent collapse of
financial as well as other related systems. Risk management in the banking sector include the
assets liability management, credit risk and market risk. By following best practices banking
sector can prevent crises because 2008 financial crises affect the whole world badly. So it
important for the government to review banking policies on regular basis and make sure that
banks follow the rules and ethical practices which help the economy to prevent financial crises.
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Chen, Xu and Yang (2012) state that systemic risk caused by the macro economic factors
in the economy which control investors and companies. These kind of risk involves at the time
of investment where which include the risk and there is high chances of fluctuation in the
returns. It consist undermined events which related to the daily life and beyond the investor's
control. If individual invest in risky instrument then it is obvious to have risk or if they individual
or organisation wanted to be risk free then invest in risk free investments. Mostly higher return
securities are more risky and lower return instrument have low risk. That is why investor always
accept the investment policies before doing any investment. In the systematic risk, it is always
seen that opportunity cost of one affect the another one investment. Short term or long term debt
for the company roll-over the risk because higher liquidity increase the cost over the business
cycle. As per Whilst, systematic risk mainly affect the bank's shareholders ans change in
systemic risk not only affect shareholders of banks along with this other potential participative in
the wider economy. Basically it is related to the bank defaulters are related to the volatility of
banks returns rather then beta of banks. Change in the systemic risk can be considered s change
in the leverage of banks. Beta of portfolio is define in terms of ratio of portfolio returns along
with market or variance of market return. Portfolio beta is considered as standard deviation that
is elated to the market return and correlation consist of market or portfolio returns.
According to Duca and Peltonen (2013), they develop a framework for the prediction of
those events which affect the real potential cost that is period of extreme financial instability.
This prediction based on two factors such as, first is use of Financial Stress Index to identify the
initial date of financial crises and second one is use of discrete choice model which combined the
domestic & global macro financial indicator and predict systemic financial crisis.
TASK 3
Concept of Systemic Risk
Traditionally, Risk Management has been concerned with controlling and mitigation of
systemic and project specific risks. A Systemic Risk is concerned mainly with the design and
external environmental factors (Bollen and et.al., 2015). It is the possibility of industrial or
economic failure due to an event triggered at an organisational level leading to severe instability.
A company that holds a significant amount of control over a particular industry or economy is
more prone to be at Systemic Risk. This risk is known to cause a cascading effect on the industry
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and other related areas present in the economy. It is important to note that Systemic Risk is
different from Market or Systematic Risk experienced by investors in the stock market of a given
economy and is limited to a certain asset or item that is bought or sold in that market
(Brunnermeier and Oehmke, 2013). Lehman Brothers, as an organisation, had a very low risk
appetite which led to its bankruptcy. The mortgage crisis as well as crash of banking sectors also
did not lead to a favourable situation for the business, thus, leading to the banks dissolution
eventually.
A government may use such a risk so as to intervene in the affairs of the economy with a
belief that the problems triggered due to instable event at an organizational level do not follow
through to the other sectors, related or not. One distinctive example of failure of system due to
the presence of such a risk is related to the Financial Crisis of 2008. Also known as the 'Global
Financial Crisis', it is considered to be one of the most coveted and serious collapse of banking
systems in United States as well as other countries (Brunnermeier, Dong and Palia, 2012). The
Lehman Brothers were the source of such a global event due to its size and degree of integration
with the systems of U.S. Economy. Not only U.S. but the after-effects of Recession were felt on
a global scale.
Global Financial Crisis (GFC) 2008
Main Cause:
The triggering point of 2008 Crisis is associated with Lehman Brothers. However, signs
of financial stress had already started to become prominent in 2006 when the housing prices
started to fall excessively. This resulted in an increase in demand for real estate causing many to
take loans from banks. These loans were allowed by banks at 100 percent or more of their value
of their new homes leading them to make huge investments in Sub-prime Areas. As per the
Gramm-Rudman Act, Banks were allowed to engage in trading activities especially related to
derivative market that were eventually sold to investors. Such securities involved a mortgage
component that required investors to collateral their home loans, further increasing the demand
in the sector. The Federal Reserve was of the notion that this crisis would only affect the housing
market and would not create problems for other sectors of the economy. On 15 September, 2008,
the Lehman Brothers filed for bankruptcy which was the fourth largest investment bank in the
country at the time. Here, Lehman Brothers, as an investment bank, posed the most systemic risk
to the U.S. Economy (Chen and et.al., 2014).
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Links:
Bailouts made in the form of purchasing toxic banks by the Bush Administration in an
effort to save the Banks from being completely dissolved and injection of enough liquidity
helped sustain most of the damage caused by The Brothers. The panic caused among investors
due to the affairs of Sub-Prime Mortgage Crisis and Investment Banking Industry direly affected
the other sectors of U.S. as well as other global economies, specifically the stock markets. The
direct hit of this event was felt in Wall Street, Main Street and the Banking Industry.
Being an unregulated industry, U.S. Investment Banking Industry proved to fail without
considerable intervention from Bush Administration. Losses from Lehman brothers, panic
among investors as well as Sub-prime Mortgage Crisis all contributed to the Global Financial
Crisis of 2008. Thus, leading to crash of money market mutual funds as the investors fled. One
can see that Lehman Brothers inefficiency to perceive the financial stress and other signs led to
its demise (Davies and McGoey, 2012). This created an event of systemic risk, mainly born at an
organisational level of The Brothers' Administration and making its way to other financial
systems worldwide. This is also due to the fact that no one foresaw a potential crisis of such a
magnitude when it actually triggered, not even the U.S. Government or Federal Reserve itself.
Cascading Effect of Crisis:
Global Financial Crisis of 2008 led to the fall of not only Wall Street as well as other
Stock Exchanges worldwide but also of Banking Systems which are the core of operations for
any economy. Systemic Risk leads to a ripple or cascading effect as it causes severe instability
among the company, its relevant industry and the economy as a whole.
One of the two main reasons that caused a cascading effect of the crisis led by Lehman
Brothers to Australia and other countries was the usage of U.S. Dollar ($) as the base for foreign
exchange transactions all around the world. Any rise or fall in the Dollar would effect the
movement of others in respect to it, especially those which use Dollar as their official currency
too, such as Australia. Another important factor was the interconnectivity of global financial
systems of various economies.
During the GFC, some of the economies were able to retrieve back to their normal
operational cycles even though they were heavily impaired due to the event. Australian Economy
also felt the effect of Crisis that started in U.S. In late 2007, the economy was almost immune to
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the credit crisis looming in other countries due to the financial crisis. However, it performed well
as compared to its other counterparts (Huang and et.al., 2013).
Risk Appetite of the Australian Banking Sector:
Compared to its U.S. Counterparts, Australian Banking Sector had a much larger risk
appetite. Lehman Brothers was a huge investment banking business with most of its banking
operations integrated in the U.S. Economy, hence any effect on its operations had a direct impact
on the economy and vice versa. The Economy implemented a Deposit and Wholesale Funding
Guarantees (DWFG) Scheme which assured the citizens that their deposits made with the Banks
and they are not exposed to any sort of risk regarding the same. This scheme was one of the
many responses that came due to the effect of Global Financial Crisis felt in various parts of the
world. The Banking Structure of Australia comprised five major banks and nine regional ones
along with 11 local banking subsidiaries as well as 29 foreign bank branches operative at the
time of crisis. Out of which, 65% of the local bank assets were owned by Larger Banks.
Global Financial Systems connected the U.S. based investment Bank with those in
Australia too, specifically in the form of foreign banking branches. Since the foreign banks were
also operative in Australia, the Lehman Brothers' involvement in the mortgage crisis acted as a
catalyst for the Australian banks to reduce the risk of collapse too. Lower risk appetite of
Lehman Brothers led to the identification of such consequences in other economies too including
Australian based Banks.
Introduction of DWFG helped in reducing the banks' exposure to systemic risk created
by the Lehman Brothers Investment Bank as well as the crisis of Sub-Prime Mortgage. The
Scheme also ensured that any risk of going bankrupt for the operating banks is substantially
minimized as any effect on one would adversely affect the others and the economy as a whole
(Huang, Zhou and Zhu, 2012).
From the above discussion, one can see how systemic risk played a role in creating one of
the biggest economic disasters in the world. One that would not only affect one sector but global
economies as a whole, forever changing the way various industries and financial systems
operated around the world.
TASK 4
As observed above in the case of Global Financial Crisis of 2008, there were many
underlying factors that could be termed as the main reason for causing the trouble. However, the
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most prominent causes of them all were substantial foreign borrowings, Weak Monetary
Policies, reckless lending habits and lenient regulations (Sedunov, 2016). All these contributed to
the event, although, it must be kept in mind that there were signs of financial stress that were
promptly ignored or set aside as unimportant which eventually led to the GFC. If only these
variables were taken seriously the crisis could have been easily avoided. Considering this as a
project, it can be said that here, a matter of being held accountable comes into play. Being a
prompt manager or a leader, it is important to analyse each and every aspect of stressful sign
indicated by a project or an event.
In the context of Global Financial Crisis, one of the main issue was the falling housing
rates in excess of which their was a incremental change in the demand among investors. In
addition to this, the regulation of mortgage brokers was highly lax as they were given much more
freedom to do as they want from the government's side. This led to an increase in bad decisions
made by these brokers as well as banks which led to presence of Bad Loans, Hedge Funds and
thus, excessive leverage (Lane, 2013). The other problem was the credibility problem. Many of
the loan seekers were allowed loans in 100 percent or more of the value of their homes with a
rationale that excessive demand and falling prices would be able to nullify the effect of such
loans. Also, derivatives were not a concept that fully resonated with the government as well as
investors especially in terms of the effect they would have and threat they would pose to the
economy, if used nonchalantly. Regulating such underlying assets could have also prevented the
occurrence of financial crisis across the globe.
Taking Risk Management as the measure to control exposure of risk that the Lehman
Brothers were unable to If the decisions taken by the leaders would have been much more
rational and unbiased, taking into account all the possible effects, consequences and causes, the
Financial Crisis of 2008 could have been avoided in its entirety.
CONCLUSION
From the above discussion, it has been concluded that systematic or systemic risk affect
the macro economic environment. Banks need to follow various practices which help them to
manage their risk by use of risk management practice. It has been observed that, global financial
crises affect the whole banking industry as well as economy of worlds. Australian banking sector
implement the Deposit and Wholesale Funding Guarantees (DWFG) that provide assurance and
expose the risk related to the investment and provide clear information to their citizens.
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REFERENCE
Books & Journals
Acemoglu, D., Ozdaglar, A. and Tahbaz-Salehi, A., 2015. Systemic risk and stability in financial
networks. American Economic Review. 105(2). pp.564-608.
Acharya, V. V. and et.al., 2017. Measuring systemic risk. The Review of Financial Studies.
30(1). pp.2-47.
Bessis, J., 2015. Risk management in banking. John Wiley & Sons.
Bisias, D. and et.al., 2012. A survey of systemic risk analytics. Annu. Rev. Financ. Econ. 4(1).
pp.255-296.
Bollen, B. and et.al., 2015. The Global Financial Crisis and Its Impact on A ustralian Bank
Risk. International Review of Finance. 15(1). pp.89-111.
Brunnermeier, M. K. and Oehmke, M., 2013. Bubbles, financial crises, and systemic risk.
In Handbook of the Economics of Finance (Vol. 2, pp. 1221-1288). Elsevier.
Brunnermeier, M. K., Dong, G. N. and Palia, D., 2012. Banks’ non-interest income and systemic
risk. In AFA 2012 Chicago Meetings Paper.
Chen, H. and et.al., 2014. Systemic risk and the interconnectedness between banks and insurers:
An econometric analysis. Journal of Risk and Insurance. 81(3). pp.623-652.
Chen, H., Xu, Y. and Yang, J., 2012. Systematic risk, debt maturity, and the term structure of
credit spreads (No. w18367). National Bureau of Economic Research.
Davies, W. and McGoey, L., 2012. Rationalities of ignorance: on financial crisis and the
ambivalence of neo-liberal epistemology. Economy and Society. 41(1). pp.64-83.
Dionne, G., 2013. Risk management: History, definition, and critique. Risk Management and
Insurance Review, 16(2), pp.147-166.
Duca, M.L. and Peltonen, T.A., 2013. Assessing systemic risks and predicting systemic
events. Journal of Banking & Finance, 37(7), pp.2183-2195.
Huang, X. and et.al., 2013. Cascading failures in bi-partite graphs: model for systemic risk
propagation. Scientific reports. 3. p.1219.
Huang, X., Zhou, H. and Zhu, H., 2012. Systemic risk contributions. Journal of financial
services research. 42(1-2). pp.55-83.
Lane, P. R., 2013. Financial globalisation and the crisis. Open Economies Review. 24(3). pp.555-
580.
Sedunov, J., 2016. What is the systemic risk exposure of financial institutions?. Journal of
Financial Stability. 24. pp.71-87.
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