In this brief, Darryll Hendricks argues that before getting into the issues of the organization of systemic risk regulation that legislators and regulators need to agree on the nature of the problem. The note provides some background. It is divided into four parts. The first offers two alternative definitions of systemic risk:
- A systemic risk is a risk that an event will trigger a loss of confidence in a substantial portion of the financial system that is serious enough to have adverse consequences for the real economy.
- A systemic risk is the risk of a phase transition from one equilibrium to another, much less optimal equilibrium, characterized by multiple self-reinforcing feedback mechanisms making it difficult to reverse.
The second part identifies three types of systemic risks:
- Bank runs occur when confidence erodes and bank depositors demand repayment at par. Banks are forced to liquidate inherently illiquid investments at distressed values. Contagion spreads to institutions perceived to be exposed to the same "toxic" asset classes or to other banks in danger of failing.
- Financial market collapses occur when a speculative bubble in some asset class runs out of steam and is followed by a bust. If the declines are deep and widespread enough, they spur concern about additional losses, increasing uncertainty and risk aversion. As firms sell assets to cover margins and reduce exposures, other asset classes can lose value too, providing mutually reinforcing feedback and making the collapse general.
- Infrastructure collapses occur when concerns about the integrity of market mechanisms for transacting can lead to a widespread reduction in market activity and liquidity.
The third part discusses the notion of systemically significant institutions, large, complex, inter-connected financial institutions, and the issues and options associated with preventing them from being threats to systemic stability through disorderly failures. The final part discusses financial models - consistent frameworks for thinking about systems - and how they are evolving.
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