SYSTEMIC
RISKS
Understanding Causes, Impacts,
and Regulatory Approaches
Prepared by: Dr Bui Thu Hien
1.
INTRODUCTION TO SYSTEMIC RISKS
► Definition: Systemic risk refers to the potential
collapse of an entire financial system or market,
rather than just a single institution or entity.
► It is often characterized by a "domino effect"
where the failure of one financial entity can trigger
failures across multiple interconnected institutions
and markets.
► Governments, central banks, and international
organizations actively monitor systemic risks to
prevent financial crises that can disrupt global
economies.
2.
KEY CHARACTERISTICS OF SYSTEMIC
RISKS
Interconnectedness Loss of Confidence
Financial institutions, markets, and When investors and depositors lose trust
economies are highly linked, meaning in the financial system, it can lead to
that distress in one area can quickly capital flight, liquidity shortages, and
spread to others. financial instability.
Liquidity Crisis Regulatory Complexity
A sudden withdrawal of funds can cause Systemic risk is difficult to predict and
liquidity shortages, making it difficult for control because it involves multiple
banks and businesses to meet financial sectors and global markets.
obligations.
3. CAUSES OF SYSTEMIC RISKS
Financial Institution
Failures Market-Based Risks External Shocks
► Bank Runs: When depositors ► Market Volatility: Sharp ► Macroeconomic Crises:
withdraw funds en masse, fluctuations in stock and bond Recession, inflation spikes,
causing a bank’s failure. prices can create panic and and political instability.
► Leverage & Liquidity uncertainty. ► Technological Risks:
Crisis: Excessive borrowing ► Hedge Fund and Investment Cybersecurity threats
and lack of liquidity can lead Failures: Highly leveraged funds disrupting financial systems.
to insolvency. (e.g., Long-Term Capital ► Regulatory Failures: Weak
► Interbank Dependencies: Management in 1998) can
oversight leading to
Banks lend to each other; if amplify systemic risks.
unchecked risk-taking by
one bank fails, others can ► Disintermediation: The shift financial institutions.
follow due to unpaid debts. from traditional banking to
capital markets reduces
oversight and increases risks.
4. EXAMPLES OF SYSTEMIC RISKS
The Great Depression Bank failures, stock market crash, and economic
►
01 1929 - 1933 downturn leading to mass unemployment.
► Lack of regulation and government intervention
worsened the crisis.
Global Financial Crisis ► Triggered by subprime mortgage collapse in the U.S.,
02 2008
leading to Lehman Brothers’ bankruptcy.
► Global credit crunch caused failures in banking systems
worldwide.
► Governments responded with massive bailouts and
new regulatory frameworks (e.g., Dodd-Frank Act,
Basel III).
COVID-19 Economic Impact
03 2020 - 2021 ► Global shutdowns caused liquidity shortages and
economic slowdowns.
► Central banks intervened with stimulus packages
and financial support to prevent systemic
collapse.
5. CASE STUDY
THE 2008 FINANCIAL
CRISIS
CASE STUDY 5.1. Causes of the 2008 Financial
Crisis Excessive Risk-Taking by Banks
Banks and mortgage lenders issued
Housing Market Collapse subprime loans to borrowers with poor
► Housing prices began falling in
credit histories.
2007, leading to a wave of
mortgage defaults. Over-Reliance on Credit Ratings
► The value of MBS plummeted, Credit rating agencies, i.e. Moody’s
CRISIS and S&P, gave high ratings to risky
causing huge losses for banks
and investment firms. MBS, misleading investors into
believing they were safe
investments.
Interconnectedness of Financial
Regulatory Failures Institutions
► The deregulation of the financial
► Large banks and investment firms were
industry, i.e. the repeal of the Glass- heavily invested in the same financial
Steagall Act, allowed banks to take products.
excessive risks.
► The financial system relied on short-term
► There was little oversight of complex borrowing, making institutions vulnerable
financial instruments, i.e. CDS, which when markets lost confidence.
amplified losses when the crisis
CASE STUDY 5.2. The Domino Effect
Lehman Brothers
01 Lehman had billions of dollars in mortgage-backed securities that
became worthless when housing prices collapsed.
Stock market & Interbank
02 When Lehman failed, panic spread through the financial system,
causing stock markets to crash and interbank lending to freeze.
Financial institutions
03 Other major financial institutions, such as AIG, Citigroup, and Merrill
Lynch, also faced severe losses, forcing the government to
intervene.
Economy
04 Businesses and consumers found it difficult to get loans,
leading to a sharp decline in economic activity and a
global recession.
CASE STUDY 5.3. Government Response and
Reforms
Bank The U.S. government passed the Troubled Asset
Relief Program, a $700 billion bailout to stabilize
Bailouts banks.
and
The Federal Reserve provided emergency liquidity to
Stimulus
financial institutions and cut interest rates to near
Packages zero.
The Dodd-Frank Act (2010) introduced stricter
regulations: stress tests for banks and restrictions on
risky investments.
Regulatory
The Volcker Rule banned commercial banks from
Reforms engaging in speculative trading.
The Basel III Framework increased capital
requirements for banks to improve financial stability.
Banks and financial institutions improved their risk
Changes in
assessment models to better evaluate potential
Risk economic downturns.
Manageme
Credit rating agencies were required to be more
nt transparent in their evaluations.
CASE STUDY 5.4. Lessons Learned
Financial Financial
Central Banks
Institutions Instruments
► Complex financial
► Excessive risk-taking instruments should be
► Quick interventions,
and lack of oversight clearly understood by such as providing
can create investors, and risk liquidity and lowering
vulnerabilities in the levels should be interest rates, can
financial system. accurately assessed. prevent a total collapse.
However, relying too
► Regulators must ensure ► Credit rating agencies much on bailouts can
banks have sufficient must avoid conflicts of encourage risky
capital and are not interest that lead to behavior (moral
excessively leveraged. misrepresentations of hazard).
financial stability.
6. Key Measures of Systemic Risk
1. Financial Stress Index (FSI)
● - Aggregates financial stress indicators like volatility,
interest rate spreads, and equity returns.
2. Market-Based Indicators
● - Credit Default Swaps (CDS) spreads.
● - LIBOR spreads (LIBOR-OIS, LIBOR-TBILL).
● - Stock market correlations.
3. Bank-Specific Indicators
● - Systemic Risk Index (SI) using structural credit models.
● - Multivariate Densities (MD) from CDS data.
● - CoVaR: Contribution of a bank to system-wide risk.
Financial Stress Index (FSI)
• Measures financial instability across different
market segments.
• Components include:
● - Interest rate spreads
● - Stock market volatility
● - Exchange rate fluctuations
• Used to identify systemic financial crises and
predict economic downturns.
Market-Based Indicators
• Credit Default Swap (CDS) spreads:
● - Measure default risk of banks and systemic
stress.
● - First Principal Component of CDS portfolio is a
key indicator.
• LIBOR-OIS and LIBOR-TBILL spreads:
● - Indicate liquidity and credit risk in interbank
lending markets.
• Stock Market Correlations:
● - High correlation among financial institutions
Bank-Specific Indicators
• Systemic Risk Index (SI):
● - Uses credit risk models to estimate default
probabilities.
• Multivariate Densities (MD):
● - Joint probability of distress among banks.
• CoVaR:
● - Measures the risk a single institution
contributes to the whole system.
•No single measure captures systemic risk
completely.
• Combining financial stress indicators, market-
based measures, and bank-specific models
improves systemic risk assessment.
• Policymakers should monitor these measures for
early warning signals to prevent crises.
TRADITIONA Ensures financial Mandates that banks
institutions maintain hold sufficient liquid
enough capital to assets to meet short-
Protects depositors to absorb losses. term obligations.
L
prevent bank runs. Capital Adequacy Liquidity
Deposit Insurance Requirements Requirements
(Basel III)
7. REGULATORY APPROACHES TO SYSTEMIC RISK
Stress Testing & Global
MODERN
Risk Transparency & Coordination Cybersecurity
Simulations Disclosure Rules (IMF, Financial Measures
Analyzing worst-case Requiring institutions Stability Board) Strengthening
scenarios to assess to disclose risks and Ensuring cross-border digital
financial institution exposures to prevent collaboration in infrastructure to
resilience hidden liabilities. financial regulation prevent cyber
threats that can
destabilize
financial markets.
8.
CONCLUSION
► Systemic risk remains a major challenge in global
finance and requires proactive management.
► A combination of regulatory oversight, financial
reforms, and risk mitigation strategies is
essential to preventing future crises.
► The financial system must balance innovation and
stability to foster economic growth while managing
risks.
THANK YOU!
QUESTIONS & DISCUSSION.