Sample Economics Essays on Systemic Risk in the Banking Sector

Introduction

The finance and banking sectors often face various risks that can result in immense loss both at the company and national levels. According to Cerutti, Claessens, and McGuire, systemic risk is the probability of a failure or an event at a company level to result in instability or collapse of an entire industry (3). In the banking sector, big companies with large market shares in any given country have the potential to be considered a systemic risk since they are rarely considered capable of collapsing. Many other companies in the industry, therefore, are linked to them in intricate patterns, whereby the failure of any such systemic risks would result in a domino effect causing instability in the entire industry. Compared to entire industries, systemic risks are relatively large. An example of such a risk was observed in the Lehman Brothers’ Company, in which the failure of one company resulted in an international financial crisis. Systemic risks can be difficult to describe in the context of distinct economic theories, yet there are clear pieces of evidence of the involvement of such risks in economics and their impacts on the micro and macroeconomic contexts. In this essay, a comparison is made between the findings of a research paper on systemic risks and the findings of other similar papers in both the context of economic theories and in terms of content.

Systemic Risks and the Banking Sector

Systemic risks are most prevalent in the banking industry, where they can be defined within two concepts; the risk of a bank and the bank’s risk in the system. The global financial shocks in recent years have shown that in the banking sector, shocks in one part of a country can result in system-wide disadvantages. In particular, the capacity of a bank to manage its risk is a crucial performance factor, measured by outcomes such as the availability of institutional approaches to coordination of national issues; reduced complexity of interactions in the international system; and availability of international data to capture dimensions of systemic risks (Gulzar 532). Each of these factors is an indication of how well a company in the sector can manage its potential to cause harm to the international banking scene. Systemic risks can be measured in the banking sector in terms of the systemic expected shortfalls, the expected marginal shortfalls, and the propensity for the institution to be undercapitalized in case there is rampant under-capitalization in the system.

The banking sector contributes significantly to each nation’s economy. Gulzar describes the banking sector as the backbone of any economy, providing financial assistance to governments as well as the private sector. Countries with stable financial sectors enjoy greater economic growth compared to those in which the sector faces instabilities. In the developed countries, the banking sector has weaker impacts on the economic growth, and the impact decreases as the economic strength of the country increases. The structuring of the sector is itself such that individual risks at any institution are dealt with in time, resulting in stability of the entire system. In some cases, individual systems may be fragile and vulnerable to macroeconomic shocks. Considering an institutional risk in isolation can help to identify areas of potential shortfalls and subsequently to determine the areas in need of change or improvement. In the article by van Oordt and Zhou, the concept of systemic risk is explored in the banking sector (365-384). The two authors explore a system that can be used for measurement of systemic risk within the banking industry and explain why differences in the relationships between bank models and systemic risks affect micro and macro-prudential perspectives and may also have implications on banking regulation.

The theories of risk and uncertainty and market failures can be considered the most valid explanations for the interactions between systemic risks and the economy. The conventional theory of risk and uncertainty states that risk is a situation in which all the probable consequences of an action or a decision are known beforehand. However, the events that would happen as a result of the risk are unknown. Therefore, it becomes easy to plan for risk management, budgeting, and cost-benefit analysis. Risks in the financial sector fall within this classification, in that, it is difficult to predict what would happen, as was with the case of the Lehman Brothers’ company failure. In the contemporary economic times, there have been significant measures for the management of such systemic risks due to the awareness of what could happen. Preparation through additional regulations and stringent control of institutions considered systemic risks is sufficient proof of the role of risks in the banking sector.

The second theory, which is the theory of market failure, directly describes the potential impacts of any systemic risk related event in the financial sector. Market failure describes a situation in which the allocation of goods and services in a free market is insufficient (Acharya and Others 43). This can be attributed to various factors including availability of public goods, externalities, asymmetric information, and lack of property rights. In the context of systemic risk, externalities and asymmetric information can be the most probable causes of shocks in the market. Asymmetric information can be likened to the situation that occurred ahead of the 2008 financial crisis, in which Lehman Brothers’ Company had been aware of the company’s financial situation but consistently represented false data, misleading the markets and thereby bolstering the failure. Similarly, externalities such as the housing bubble can also affect systemic risks due to the financial link between the two industries. Failures in other industries can also result in systemic risks, which open up the economy for greater instability at the macro level.

Systemic Risk and Economic Theory

The article by van Oordt and Zhou presents various perspectives of systemic risk, giving more detailed information than that given by Mishkin. In Chapter 12 of the textbook, Mishkin provides an overview of financial crises, with specific mention of the regulation of financial institutions (287). In this context, the book recognizes the role played by big financial institutions in macro-economic stabilization. In particular, Mishkin describes systemic risk regulation and the evaluation of financial institutions based on their potential impacts on the economy (287-288). The author further points out that an institution that is considered systemic risks are subjected to additional government regulations under the Dodd-Frank Act to reduce their probable impacts on the economy. Similarly, van Oordt and Zhou posit that institutions that are large enough to be considered systemic risks should be subjected to additional scrutiny and possibly more stringent controls (362). Through their proposed method of systemic risk measurement, the authors suggest that it is possible to predict which institutions pose a systemic risk in any nation. Both the book and the article contribute to systemic risk studies through their narration of the concept and prevention of systemic risk. Mishkin in particular, proves that government bodies, through policies and regulations, are also making efforts to reduce the possible impacts of systemic risks.

Other articles have also explored the concept of systemic risk and its role in the economy. For instance, Cerutti, Claessens, and McGuire discuss the various characteristics that can be used to identify systemic risks in financial institutions (3-18). In their article, the authors present a discussion of the role of systemic risks in the economy, alongside the characteristics that result in consideration of an institution as a systemic risk. The article by Cerutti and Others contributes to systemic risk discourses by giving a different perspective for use in the evaluation of financial institutions for systemic risk vulnerability. Through the mentioned characteristics, financial regulators can examine other institutions and categorize them accordingly. While comparing the contents of van Oordt and Zhou with those of Cerutti and Others (3-18), a lot of similarities are evident, including the possibility of measuring systemic risks using system modeling techniques. Furthermore, the two articles provide details about how systemic risks affect the performance of financial institutions and the sector at large.

Article Critique

Van Oordt and Zhou have explored the concept of systemic risk extensively, giving thought to its measurement and recommending measures for the reduction of potential systemic risk impacts (365-384). The article provides significant contributions to finance industry literature. Conventional literature on systemic risks focuses on reducing the impacts of the risk without necessarily measuring the magnitude of the risk. By addressing both the impacts and the measurement practices, the article fills a gap of great importance to the industry. Furthermore, it is relevant to financial crises management as it addresses an element of financial risk that most articles do not touch on. Since systemic risks affect entire economic systems and may even extend beyond national boundaries, finding a model that explains and can simulate the impacts of shocks in the finance industry at the macro-economic level is a plausible success.

When evaluating the efficacy of this article, one of the factors considered was the methodology used by the authors. Van Oordt and Zhou used a qualitative research methodology, in which an empirical model was used to decompose the concept of systemic risk within the banking sector (367). The methodology is similar to what most other studies on systemic risk, particularly those touching on systemic risk measurement use. For instance, the same approach was used by Acharya et al. (2-47). However, the article gives more in terms of both content and context than Mishkin (287-288). In terms of testable implications, van Oordt and Zhou link the sensitivity of a bank’s stock prices to its systemic risk levels (367). This can be tested through models similar to those presented by the authors, which are simulated based on externalities. It is, therefore, conclusive that the article satisfies the requirements for reasonableness and can have positive implications on systemic risk measurement and management.

Conclusion

A financial institution becomes a systemic risk when it occupies a position of significant power relative to other players in the industry. As such, organizations attempt to control or reduce the impacts of systemic risks both internally and through the involvement of several external parties, who are also key participants in the macro-economic context. An article by van Oordt and Zhou explores the concept of systemic risk through various models of measurement, which can be used for the estimation and management of risks. This article provides a needed dearth to the literature on systemic risks. Furthermore, it can be considered a credible and accurate resource due to the relevance of the information presented with the context of this essay, the credibility of sources used, and the match between the authors’ findings and those from other resources. Similarly, the other articles and the book provide essential information that can be used for institutional classification as well as for the identification of systemic risks among financial institutions. Through these materials, it is possible to not only evaluate but also to measure systemic risks, which can be recognized as a strong contribution to the finance industry.

 

Works Cited

Acharya, Viral V., Pederssen, Lasse H., Philippon, Thomas, and Richardson, Matthew. “Measuring Systemic Risk.”The Review of Financial Studies, vol. 30, no. 1, 2017, pp. 2-47. academic.oup.com/rfs/article/30/1/2/2682977. Accessed 29 May 2019.

Cerutti, Eugenio, Claessens, Stijn and McGuire, Patrick. “Systemic Risks in Global Banking: What Available Data can Tell Us and What More Data are Needed?”NBER Working Paper Series, 2012. www.nber.org/papers/w18531.pdf. Accessed 29 May 2019.

Gulzar, Amir. “The Contribution of the Financial Sector in the Economic Growth of Pakistan: A Literature Review on Growth Theories and Indicators of Economic Growth.”Journal of Business and Financial Affairs, vol. 7, no. 3, 2018, pp. 532. www.omicsonline.org/open-access/the-contribution-of-the-financial-sector-in-the-economic-growth-of-pakistan-a-literature-review-on-growth-theories-and-indicators-2167-0234-1000352-104897.html. Accessed 29 May 2019.

Mishkin, Frederic S. The Economics of Money, Banking, and Financial Markets, 11th Ed. Pearson Publishing, 2016.

Van Oordt, Maarten and Zhou, Chen. “Systemic Risk and Bank Business Models.”Journal of Applied Econometrics, vol. 34, 2019, pp. 365- 384. onlinelibrary.wiley.com/doi/epdf/10.1002/jae.2666. Accessed 29 May 2019.