FINANCIAL MARKETS & RISK

Financial Markets & Risk

Financial Markets & Risk

Introduction

Subsequent to the financial crisis in 2007, policy makers identified a new risk, which is affecting the entire financial system. It came to be known as Systemic Risk. According to Bank for International Settlements, the term is defined as “the risk that the failure of a participant to meet its contractual obligations may in turn cause other participants to default with a chain reaction leading to broader financial difficulties” (BIS 1994, 177). In the wake, of recent financial crisis, a new wave of banking reforms has started worldwide. In United Kingdom, role of universal banks are of pivot importance because they have contributed significantly for the development of the country. At the same time, the hugeness of banking entity also makes it systemically important financial institution.

Systemic risk

Systemic risk is the probability or risk of collapse in an entire system rather than collapse in individual components and usually supported / backed by correlation among all or most of the parts. Consequently, within the context of the banking industry, it is evident by the positive correlation and series of bank failures within a single geographic region, country, and continent or worldwide. Systemic risk also may arise in other divisions of the financial industry. For instance, in any securities markets as supported by coincident decrease in the prices of the multitude of the securities in one or more than one markets in a single region or across regions. Systemic risk may be nationwide or transnational (Kaufman & Scott, 2003).

Systemic risk is referring to the event risk which can trigger a collapse in an industry for instance banking sector. It is different from systematic risk, which reflects, the market risk of the portfolio. The exact definition of systemic risk has varied from financial gurus. Some have associated it with narrow problems arising as a result of the failed payment system, while other people have employed it to denote crisis situation in the financial system, which is caused by failure of the system. By and large, systemic risk can be expressed as a risk arising as an outcome of an event at some certain firm level which is so severely detrimental that it hit the entire financial system nationwide or globally.

Systematic / Unsystematic Risk

Systemic risk should not be mixed with systematic risk. Both are different terms and are employed for different situations. Contrary to systemic risk, systematic risk is clearly defined as the risk inbuilt in the cumulative market that could not be mitigated by diversification. Common origins of systematic risks are interest rates, recessions, or even wars. Since such activities are out of bound of the company, this interest cannot be mitigated by any firm through the use of diversification. On the other hand, if the risk can be mitigated by way of diversification, it will be regarded as unsystematic risk. This risk is firm specific (www.investopedia.com).

Systemically important financial institutions (SIFI's)

The term seeks to identify and categorize those financial ...