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Explaining systemic risk

Posted on 10-Oct-2011 by raisepartner

During the Systemic Risk and Data Issues conference held in Washington last week, we had the opportunity to hear the economist Anton Korinek* present a crystal-clear model of systemic risk based on financial amplifications**:

1. Banks raise finance from households and invest in risky projects (assets).

2. In times of crisis (economic shock), the returns of these risky assets are low.

3. Contracted debts and tightening financial constraints force them to sell their assets at a low price (“fire sales”).

4. This triggers financial amplification effects: the more banks sell, the larger the decline in asset prices; as a consequence, banks need to sell even more assets to raise enough liquidity and meet a given repayment obligation.

These financial amplifications are characteristic of systemic risk:

References

* Anton Korinek (http://www.korinek.com/) has been an assistant professor of economics at the University of Maryland since 2007, after receiving his PhD from Columbia University. His research focuses on international finance and macroeconomics, with special emphasis on financial crises.

** Anton Korinek , « Systemic Risk-Taking: Amplification Effects, Externalities, and Regulatory Responses », Feb 2011.