What Is Systemic Risk, and Do Bank Regulators Retard or Contribute to It?

TLDR

Systemic risk, defined as the probability of breakdowns across an entire financial system, is feared in banking and is often compared to a fire in a crowded theater, yet its definition is less clear and regulators have been accused of unintentionally contributing to it. This paper seeks to assess how bank regulators affect systemic risk and to propose efficient strategies for reducing its probability and impact. The authors review alternative definitions and sources of risk, historical evidence, market self‑protection mechanisms, and regulatory measures adopted by banks. Banking risk is evidenced by high correlation and clustering of failures across countries, demonstrating systemic risk.

Abstract

One of the most feared events in banking is the cry of risk. It matches the fear of a cry of fire in a crowded theater or other gatherings. But unlike fire, the term systemic is less clearly defined. Moreover, unlike fire fighters, who are rarely accused of sparking or spreading rather than extinguishing fires, bank regulators have at times been accused of, albeit unintentionally, contributing to rather than retarding risk. This paper discusses the alternative definitions and sources of risk, reviews briefly the historical evidence of risk in banking, describes how financial markets have traditionally protected themselves from risk, evaluates the regulations adopted by bank regulators to reduce both the probability of risk and the damage caused by it if and when it may occur, and makes recommendations for efficiently curtailing risk in banking. I Systemic Risk Systemic risk refers to the risk or probability of breakdowns in an entire system, as opposed to breakdowns in individual parts or components, and is evidenced by comovements (correlation) among most or all the parts. Thus, risk in banking is evidenced by high correlation and clustering of bank failures in a country, a number of countries, or globally. Systemic risk may also