ECB on systemic risk

Jean-Claude Trichet, President of the ECB spoke on this subject today:  Systemic Risk

Trichet says

“One of the greatest challenges for economics and public policy at this time is to restore financial and economic stability, and to improve the future functioning of financial systems. A pre-condition for meeting this challenge is a deep understanding of the nature of systemic risk…

How is it that financial instability can be triggered by initially self-contained events, which are then transmitted so widely that the fallout ultimately reaches systemic dimensions?

ECB research by Philipp Hartmann and others, which has investigated systemic risk for at least a decade, suggests that there are three particularly important ways in which this can happen. [2]

The first is contagion. The failure of one financial intermediary can lead to failures of other financial intermediaries, even when the latter have not invested in the same risks and are not subject to the same original shock as the former. [3]

Second, widespread financial imbalances can build up over time and then unwind abruptly. Hyman Minsky described how in good times consumption and investment increase, generating income, which fuels the financing of more consumption and investment but also the neglect of increasing risks. Even small events can then lead to a re-pricing of risk and an endogenous unravelling of the credit boom, which then adversely affects many intermediaries and markets at the same time. [4]

Third, negative aggregate shocks can adversely affect intermediaries and markets simultaneously. Historical research has shown that many banking crises were related to economic downturns.[5] Note that the three mechanisms can happen independently or they can reinforce each other.”

He identifies externalities, asymmetric information, and “powerful feedback and amplification mechanisms” as “features of financial systems that make them particularly prone to these forms of systemic risk”.

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