What is systemic risk?

Systemic risk occurs when liquidity shortages or solvency failures in some financial institutions spread through the system, causing widespread economic disruption.

Amplification channels include liquidity spirals, credit rationing, and interbank contagion, where fire sales and counterparty defaults magnify initial shocks.

Against systemic crises, macroprudential tools (capital, liquidity buffers, stress tests) are essential but politically constrained.

1. Defining Systemic Risk

Systemic risk is the potential for financial distress in one or more institutions to spread throughout the financial system, resulting in widespread economic disruption. It typically arises through two primary channels:

• Liquidity risk: Institutions cannot meet short-term obligations, even if solvent on paper.

• Equity/solvency risk: The market value of assets falls below liabilities, triggering insolvency.

When systemic risk materializes, its effects propagate through interconnections, including interbank exposures, collateralized funding, and market confidence. As Brunnermeier and Pedersen (2012) describe, market and funding liquidity interact in feedback loops that can amplify initial shocks into system-wide crises (Harvard Corp-Gov Review).

2. Amplification Channels

Systemic crises rarely occur due to a single institutional failure. Amplification arises through:

1. Liquidity spirals: Funding shortages force asset sales, lowering prices and triggering margin calls.

2. Credit rationing: Banks hoard resources to preserve liquidity and equity, sharply reducing credit to households and firms.

3. Contagion via interbank networks: Fire sales and counterparty defaults spread distress across the financial system.

Network-based models like DebtRank show that indirect, second-round effects often dominate initial losses, revealing that interconnectedness itself is a systemic vulnerability (Battiston et al., 2015, arXiv).

3. Historical Systemic Crises Across Countries

Systemic crises have punctuated modern financial history, often following periods of credit expansion, asset bubbles, or external shocks:

• Finland (1991–1994) – Deregulation in the 1980s triggered a credit boom. The collapse of real estate and equities caused widespread insolvencies; GDP contracted by ~12%, and bank recapitalization cost ~13% of GDP.

• Norway (1988–1992) – A post-liberalization credit surge and oil price collapse caused interbank freezes and forced state intervention.

• Argentina (1989, 1995, 2001) – Twin crises of currency collapse and bank runs. The 2001 crisis led to output losses exceeding 70% of GDP and fiscal recapitalization near 10%.

• South Korea & Japan (1997–2001) – The Asian Financial Crisis triggered bank failures and state-led recapitalizations, as short-term foreign liabilities dried up.

• Ghana (1982) – A combination of macroeconomic shocks and weak banking governance led to a systemic crisis with an output loss exceeding 14% of GDP.

These cases demonstrate that systemic crises arise from the interaction of domestic vulnerabilities and global shocks, and that both liquidity and solvency shortfalls can paralyze credit intermediation.

4. Macroprudential Tools and Political Constraints

Macroprudential policies—like countercyclical capital buffers, liquidity coverage ratios, and loan-to-value (LTV) caps—are essential to prevent systemic crises, yet they face political economy challenges:

1. Short-term costs vs. long-term benefits

   • Stricter capital and lending requirements slow credit growth, reduce house price booms, and may cool GDP in the short run.

   • Politicians prefer growth and credit expansion before elections, delaying or softening preventive measures.

2. Financial sector lobbying

   • Banks and shadow banks resist higher buffers because they reduce leverage and profitability.

   • Lobbying can dilute or postpone the implementation of Basel III-style rules.

3. Diffuse accountability

   • Macroprudential bodies (central banks, stability councils) are often unelected.

   • Prevented crises are invisible, making it hard to justify unpopular restrictions until a crash occurs.

4. International competition and arbitrage

   • In open economies, tighter domestic rules can push credit activity offshore.

   • Policymakers may fear “losing” financial business to foreign markets and avoid strict measures.

Example: Spain’s dynamic provisioning rules before 2008 were technically sound but politically unpopular, as they curbed bank profits during the boom. After the crisis, these same tools were widely praised.

5. Lessons for Systemic Risk Management

• Financial liberalization without strong supervision increases crisis risk.

• Shadow banking and non-bank finance can shift systemic risk outside the regulatory perimeter.

• Macroprudential policies are vital but politically constrained, requiring crisis-driven political will.

• Fiscal capacity is the ultimate backstop once solvency crises overwhelm liquidity tools.

References

Laeven, L. & Valencia, F. (2018) – Systemic Banking Crises Revisited: 1970–2017, IMF Working Paper 18/206. IMF eLibrary PDF

Battiston, S., Caldarelli, G., May, R., Roukny, T., & Stiglitz, J. (2016) – The price of complexity in financial networks, PNAS. PNAS article

Brunnermeier, M., & Pedersen, L. (2012) – Market and Funding Liquidity, Harvard Law Corporate Governance Review. PDF

Martínez Pería, M. S., Majnoni, G., Jones, M. T., & Blaschke, W. (2001) – Stress Testing of Financial Systems, IMF WP 01/88. IMF PDF