Systemic Risk in Japan, Essay Example

Introduction

Systematic risk can be described as the major collapse of the entire financial system or in severe cases the entire market. In other words systematic risk can be described as the financial system instability caused by catastrophic events or conditions in the financial system. Systematic risk can also be described as the failure of the entire market system imposed by interlinkages and interdependencies in the market system through a single entity or a given cluster of entities leading to cascading failures in the financial system. This has severe consequences on the market since it can lead to institutional bankruptcy or in extreme cases it can led to the entire collapse of the market system.

In order to understand the concept of systematic risk effectively, it is important to understand it from the perspective of bank run or collapse which actually is described as the cascading effect implied on the lending institutions. The cascading effect usually is caused by ripple effects of consumer default as well as liquidity shortages through financial markets which actually results to the entire market panic creating a situation of few buyers and many sellers (Simpson & Evans, 2003).

Measurement of systemic risk

As per the property Casualty insurers association of America, there exists two measurements of assessing as well as measuring systematic risk. To begin with the first method is “too big to fail” (TBTF) which is actually connected to the TICTF tests (Eugene, 2008). Too big to fail is actually defined as the traditional analysis of assessing systematic risk in line with the government requirements or intervention. TBTF actually can be measured through an institutional size relative to the national as well as international marketplace, market share, concentration and other competitive barriers to market entry. In addition, this can be done through assessing how actually a given product can be substituted in the current market. Furthermore this can be done through measuring the possibility of the product impact on the general economy by assessing it medium impact in relation to the economy. Normally the organization will tend to measure their products and activities through the inclusion of an economic multiplier of all commercial activities which are actually dependent on the institutions business. The impact also can be defined, in the manner in which the products as well as the activities are actually correlated with the organizational business as well as the other systematic risks.

The second method of measuring systematic risk is through “too interconnected to fail”. This is one of the most useful methods of measuring systematic risk given the fact that systematic risk is usually associated with severe consequences both to financial institutions and stock markets. This kid of assessment is described as one of the intuitive assessment analysis performed by most of the federal financial reserves as an emergency relief to financial organizations. Normally this kind of measurement is actually used to determine the likelihood and the amount of medium-term net negative impact that it has to the larger economy in general. The assessment as well as the measure of systematic risk using this kind of method is very important in determining the impact of the institutional failure in conducting its business to the entire economy (Montesi, 2007). The measure is usually done by measuring all the economic multipliers of all the economic commercial activities which are dependent on the specified institution together with all the institutional products and services. To clearly determine the impact of systematic risk to the institution this test also takes into considerations the dependency of correlation between an institutional business as well as systematic risks

Types of systematic risks

There exits several kinds of systematic risks, to begin with the first kind of systematic risk is Settlement risk which actually refers to the financial losses that may occur when particular payment systems are actually used for settlement .Settlement risk is normally presented in various forms of payment systems such as credit liquidity as well as unwinding risk .The second of risk is Credit risk which actually arises when the purchaser of the asset or the buyer actually finds it hard to make payments for the assets purchased. This situation is mostly present in the credit financial institutions such as banks or other financial institutions which offers credit services to individuals (Kodres, 2000).  In this kind of systematic risk the borrower of the asset or particular loan find it very difficult to make payments hence end up defaulting as a result of poor economic conditions or deflation.

Credit risk can be viewed as the inability of particular buyer to effectively qualify for a particular loan as a result of his or her financial instability. This actually is proved when a given buyer actually orders for certain funds transfer from a certain bank but the bank finds it hard to make the credit transfers for the customer with the fear of going into an overdraft. Credit risks will usually occurs when the two sides finds it very hard to make certain payments of particular transactions simultaneously. Normally credit risk is usually divided into “first payer risk” and “receiver risk” where in actually sense the First payer risk actually refers to the risk which is usually faced by the party who makes payments in the case where the required payments have not been paid by the counterparty. The second type is Receiver risk which actually arises when the receiver actually assumes certain payments before he or she pays the final obligations. This kin d of risk usually is very common RTGS systems where actually the financial institutions have indirect users (Lehar, 2003).

The other kind of systematic risk is unwinding risk which actually comes as a result of receivers not being in a position to settle particular transaction due to some unavoidable instructions. This actually occurs when the instructions get revoked leading to the Unwinding of funds a situation which actually led to settlement failure in the netting systems. This kind of situation is usually common when the daily payments or orders are revoked without prior confirmation of the customer. This implies that Unwinding actually leads serious losses especially to the netting users or users who may have already used the amounts of cash borrowed from a particular institution hence leading to financial defaults. These costs usually led to an increase in the payments systems of financial institution especially when it comes to transaction dealing with huge amounts of money. This kind of risk allows the user to renegotiate their previous positions which actually can cause huge amount of loses in the financial institutions.

The management of this kind of risk is very difficult compared to the management of credit risk given the fact that most of the parties which are present in the netting systems requires that they are verified to prevent any further defaults. To clearly manage this kind of risk it is required that the financial institution actually acquires suffient information since the unwinding risk will actually expose very user to other user’s risk. This kind of risk is very hard to effectively manage given the fact that it affects more users in the financial chain

The final type of systematic risk is liquidity risk which actually exists when a particular payment of assets is not properly settled by the borrower. This is normally caused by lack of liquidity in the entire financial market systems. This kind of risk is usually present in both RTGS and other netting systems which are actually present in this kind of systems due to cross settlements. These kinds of gross settlements actually tends to led to greater liquidity hence exposing very participant to this kind of risk in the financial market (Rubinstein, 2006).  In order to avoid this kind of risk it is usually important to settle the transactions immediately to avoid crucial temporary liquidity shortfall. Liquidity risk can be reduced by all parties paying their amounts of money as required and on time by all the parties in the payment system. These kinds of payments are usually very important in clearing all the reserve balances since it assists in reducing the trade offs. Liquidity risk therefore is very important and mostly it occurs in the RTGS which actually are prone to suffer more than the netting systems (Altman, 2008).

How local risk might become systematic risk a case of Japan

Local risk tends to occur in any particular economy due to various factors as well as economic activities. Local risk is actually described as the risk aversion which occurs in any particular economy due to poor financial regulatory rules or monetary rules. Japan is one of the leading countries that are economically stable. Due to the recent growth and economic stability Japan as a country is really facing high risks of potential systematic risk. This is the mere fact that the country is enlarged in a serious as well as large volume of transactions which usually are done through payment systems. These payment systems are potential causes of systematic risk given the fact that they actually expose the participating financial institutions into serious intraday credit exposures. As a result of local financial institutions being involved into local transactions payment systems it actually exposes them to local risk exposure which actually after sometime it makes the financial institutions to enter into subsequent financial failures. With the fact that Japan uses high payment systems to carry out most of its transactions this puts it to high levels of systematic risks.

The fact that systematic risk is usually caused by shortage of liquidity in the local financial institutions, this is most common cause which actually leads to adverse systematic risk. By emphasizing on this fact the severe systematic risk in Japan is being caused by poor management risk tools. This is because the current financial institutions tend to understand and expect some potential risks to happen but actually don’t put in place necessary financial risk measures to control the situation. The financial institutions normally assume this kind of local risk a situation which becomes severe hence leading to systematic risks. This situation has caused severe consequences on Japan’s economy as well as financial marketing which currently are experiencing high price falls as well as liquidity shortages.

The recent financial crises in Japan due to high levels of systematic risk have been brought about by financial institutions assuming the local financial risks. Such assumption by financial institutions to curb local risks is believed to be the key cause of high losses in securitized pools and subprime markets that have lead to high levels of systematic risk. Given the fact the current financial institutions in Japan never take measures to curb this kind of risk it has led to significant decline in the house prices due financial policies Moreover this has led to a drastic drop in the prices of houses leading to unsustainable shortages in liquidity.

The other way through which a particular local risk can actually become a systematic risk is through poor implementation of monetary policies. Poor monetary policies actually can cause development of local risk into a systematic risk. This is usually caused by the poor Federal Reserve policies where the Federal Reserve instead of maintaining high levels of funds it maintains low levels of funds due to inflation or unemployment rates. When the Federal Reserve actually fails to put in place monetary policies that are very important in controlling the levels of inflation as well as unemployment it actually leads to occurrence of systematic risk. In relation to Japan the failure of  FOMC’S to put in place proper monetary policy deliberations to curb the rate of current money supply in the economy has been viewed as one of the key factors leading to the development of local risk to severe systematic risk. This has led to the drastic increases in the unemployment rates and inflation rise from 30% upto 60%.The mere fact that the monetary policy put in place by the Federal Reserve’s inflation forecast by the Japanese government does not accurately accommodate the inflation policy (Jeaner, 2009)

The other factor which can cause the development of local risk to systematic risk is the drastic drop in the interest’s rates in the economy. When an economy experiences a sharp decrease in the level of interest rates normally the lower interest’s rates actually leads to higher prices of the assets in the economy. When financial institutions actually assume the sharp decrease in the prices it leads to severe systematic risks. This actually come a result of poor Federal Reserve policies that does effectively regulate monetary policies. When poor monetary policies are put in place which do not actually control the sharp decreases in the interest rates it normally leads to high levels of systematic risks. The recent situation in the current financial markets in Japan where the markets are facing high levels of systematic risks has been stimulated from the poor Federal Reserve policies implemented by the Japanese government.

How the institutions of global governance might address the resulting problem.

In order to control this kind of situation in the financial markets, it requires that the global institutions put in place superior supervisory tools which can help in providing alternative monetary policy actions during periods of economic or financial instability. Moreover, the financial regulatory system should reform in order to effectively address the financial risks associated with systematic risks. Such reforms will ensure that the financial regulatory system is actually charged with the responsibility of regulating as well as supervising very important institutions. By reforming the financial regulatory system it ensure that potential strategies are developed  such as wind down which can actually be used to resolve systematic risk in severe circumstances of high liquidity shortages .This will actually help in reducing any critical situations which can actually lead to high levels of systematic risks.

Additional, Federal Reserve should play an important role in overseeing that the synergies that exist between the monetary policy, the lender of last resort role and the supervisory role of the bank is effectively carried out. Moreover, the Federal Reserve should ensure that the important financial institutions actually carry out role effectively through proper supervision of the community banks. Furthermore, the Federal Reserve should ensure that the there exists a big distinction between the supervisory policies and the monetary policy.

The other way is through the central bank putting in place critical economic strategies which actually promote financial stability. This actually implies that the central bank should therefore take the responsibility of implementing policies which ensures price stability in the country. Financial stability is very important for the development economy growth as well as price stability. Moreover, financial stability actually leads to development of worthy credit relations among larger financial institutions which actually leads to the development of systematic stability in both monetary and supervisory regulation (Tobin, 2008).  The central bank also plays an important role in ensuring that the principle of lenders last resort function is actually implemented effectively.

The other important way is through various governments putting in place effective organizational systemic stability regulators. The design of organizational structure is very important since it will help the financial institutions to effectively carry out the delegated responsibilities hence ensuring a financial stability in the economy. The stability of financial institutions is very important since it assists in developing macroprudential financial developments which can actually help in assessing the sources of economic wide risks as well as local risks

The other important strategy of controlling this situation is through global institutions should put in place clear objectives which actually mandate a systemic stability. Regulatory objectives are very important since they ensures that when a systematic crisis takes place then this objective actually mandate the financial institutions to clearly manage as well as resolve the crisis. This usually will occur immediately the systematic crisis occurs. The systematic regulator therefore will ensure that the financial institutions clearly monitor and put in place necessary measures which actually prevent severe consequences associated with system risk. Moreover, the implementation of clear objectives by the financial institutions is very important in strengthening as well as putting in place important regulatory supervisions that should be implemented by financial institutions in such a crisis.

Lastly the central banks should provide RTGS systems to commercial banks as well as other important financial institutions such as government agencies. Moreover, the central banks should put in place necessary measures and policies that grant intraday credit queuing systems. The establishment of intraday credit is very important since it reduces payment blockages which may arise when the banks are receiving money. This is very important since it helps the banks to ensure that underlying principles are established when it comes to idea of bank reserves.

Conclusion

Systematic risk is very crucial to any economy hence it is very important for the financial institutions to clearly put in place measures which actually reduces this kind of risk in any economy.

References

Simpson. J, Evans, P. (2003) Systemic risk in the major Eurobanking markets: Evidence from inter-bank offered rates. Curtin University:  School of Economics and Finance.

Nguyen, P. (2009). The effect of group affiliation on the risk-taking of Japanese firm.s Sydney, Australia: University of New South Wales,

Eugene F. (2008) Risk, Return and Equilibrium: Some Clarifying Comments. Journal of Finance Vol. 21, No. 2, pp. 23-30.

Montesi, C. (2007) Towards improved accounting for derivatives and hedging activities The CPA Journal, Vol: 63; Issue: 10; 23-27

Kodres, L. (2000). Foreign exchange markets: structure and systemic risks. Finance & Development, Vol: 35; Issue: 4 153-157

Altman, E. (2008). Almost everything you wanted to know about recoveries on defaulted bonds. Financial Analysts Journal , Vol 24; Issue 4 123-127

Lehar, A. (2003). Measuring Systemic Risk: A Risk Management Approach. Toronto: Calgary publishers.

Rubinstein, M (2006). A History of the Theory of Investments. New York: Bantam Books.

Jeaner, K. (2009). Measuring the risk in value at risk: a case of Japanese organizations. Chicago: Pocket Books

Tobin, J. (2008) Liquidity preference as behavior towards risk. Oxford: Penguin Books