Question

7. Systemic risk can be divided into cross sectional systemic and the time series dimension of risk.

Explain each of these, providing examples.

Answer 1

Cross-sectional risk refers to the allocation of systemic risk in the financial system at any GIVEN moment; it includes risks to financial stability arising from, concentration of their risk exposure. For example 2008 SubPrime crisis could be considered where Banks like Lehman Brothers had taken too much exposure to Housing Market through Structured Securities.

Time series dimension risk can be understood as a build-up of systemic risk over time; it includes risks of excessive debt burden, leverage and underestimation of risk during booms and overestimation of risk during recessions, thus leading to deleveraging and procyclicality. Here also 2008 SubPrime crisis can be considered as an example where Banks started providing loans with easy underwriting processes and introducing products like NINJA (No Income No Job) loans with very few verification, thus providing loans to not-so-capable borrowers overtime.