Question

3) In a speech ("Financial Reform to Address Systemic Risk") on March 10, 2009, before the Council on Foreign Relations in Washington, D.C., then chairman of the Federal Reserve Ben Bernanke concluded:

In the wake of the ongoing financial crisis, governments have moved quickly to establish a wide range of programs to support financial market functioning and foster credit flows to businesses and households. However, these necessary short-term steps must be accompanied by new policies to limit the incidence and impact of systemic risk.

a. What is meant by systemic risk?

b. Why does systemic risk impede the flow of credit available to businesses and households?

c. Why is government intervention needed to reduce systemic risk rather than relying solely on individual market participants to do so without intervention?

Answer 1

A) Systemic Risk is defined as the risk that is inherent to the entire market or the whole market segment as it affects the economy as a whole and cannot be diversified away and thus is also known as an undiversifiable risk or market risk.

Examples are change in laws, tax reforms, interest rate hikes, natural disasters, political instability, foreign policy changes, currency value changes, failure of banks, economic recessions.

B). Systemic risk is risk that effect the entire market. Systemic risk as the name itself tell the risk caused by system, that cannot avoided. When Systemic risk occures then lenders are feeling unsecure about the future and don't want to lend to businesses and Individuals. In the event of Systemic risk business and households income will decline because of companies fire their employees and when their is less demand in market the company will also suffered.

Banks don't want to lend less credit score borrower because of fear to loose money. Hence, the entire flow of credit hampered badly.

C). Government intervention is needed to reduce Systemic risk because many of the Systemic risk can reduce by government itself. In the event of bank failure, Recession in economy etc. Only government can take bold steps to revive the economy. Afterall the government is one who built laws and print money to monetize their debt. Government can provide with the help of central bank a special window to inject the funds to revive economy. Only government has enormous power to take bold steps to support the economic growth. So, government intervention is needed.