Question

When it comes to systemic risks can you name it sector in the stock market that has greatly impacted one and interest rates are trending lower as well as one where rates are trending higher?

Answer 1

Ans

Systemic risk is the risk that an event at the company or industry level could trigger a huge collapse in the economy and can create a domino effect that affects the economy of the world as a whole.

It is the risk of a major failure of a financial system, whereby a crisis occurs when providers of capital, i.e., depositors, investors and capital markets, lose trust in the users of capital, i.e., banks, borrowers, leveraged investors, etc. or in a given medium of exchange (US dollar, Japanese yen, gold, etc.). It is inherent in a market system and hence unavoidable.

The most important feature of the systemic risk is that it creates a ripple effect; i.e it spread from the unhealthier institutions to the healthier institutions through the transmission mechanism.

The institutions where this occurs are large enough that they are a significant part of the economy. And if this "Too big to fail" institution fail, that's when the systemic risk occurs.

Example 1:

The Great recession of 2008 where the real estate sector was largely affected by the fall of Lehman Brother was due to systemic risk.

The financial crisis began in 2007 with a crisis in the US subprime mortgage market. Eventually the bubble burst and led to a liquidity and credit crunch that spread to all credit and financial markets. This resulted in the economic panic.

Economic panic led to an economy-wide recession in the US. Also, the US recession led to a steep decline in global and trade investments. This recession also affected the most advanced economies. Excessive risk-taking by Lehman Brothers and other banks helped to magnify the financial impact globally. All these consequences led to worsening recession.

The crisis was eventually followed by a global economic downturn, the Great Recession in 2008-09. The European debt crisis (a crisis in the banking system of the European countries using the euro) followed later. The recession bottomed out in late 2009, but there were still long periods of slow growth in countries burdened by debt due to the financial crisis.

This led to the global recession and a huge fall in the stock markets all over the world.

Example 2:

Similar situation as the above example is being observed in the Indian market since 2018. In September of 2018, the IL&FS group in India faced huge liquidity crises. IL&FS defaulted on payments to lenders triggering panic in the markets. In lehman terms there was liquidity crunch in the market. Following the IL&FS crises Indian government laid down stringent policies for the lenders to protect the financial system from being more affected. Since lending policies were made stringent this means that the lending rates were spiked i.e. interest rates were increased. So this led to less borrowing from the corporates and manufacturing companies and in general by common man. This led to increase in prices of goods. Low purchasing power in the hand of people means that piling of the stocks of companies, leading to increase in inflation rate and slowdown in the Economy.

So when in mid of 2019, when the GDP numbers were released, it was only 5%. This was the lowest GDP rate in almost a decade of Indian economy. This liquidity crunch caused by systemic risk brought slow down in various sectors such as real estate sector, Auto sector bottomed out, FMCG sector slowed down. So as to compensate for the low GDP and improve the economy the central bank of India, RBI decreased the interest rate by 25 basis point. this was done to increase the purchasing power.

Conclusion:

So from the definition of systemic risk and from the above two example it can be clearly understood that systemic risk has huge impact on the sectors such as real estate, auto, financial sectors in the stock market as the stock prices of these sector are hugely impacted. Systemic risk also affect the interest rate. Usually initially the interest rates are lower at the beginning of systemic risk, and when the borrowing gets out of hand and the credit risk start arising that when systemic risk develop and affect the whole economic system and that's when stringent policies and the tightening of the financial system leads to interest rate trending higher.

Systemic risk has a ripple effect on the market as a whole and it effects the interest rates accordingly.