What is systemic risk?

Introduction

Our world is experiencing fast-paced, multiple, and sweeping changes (positive and adverse) clustered with technological innovations, digitalization of manufacturing, advancements in the cyber and space domain, the rise of robots, automation and artificial intelligence, and extraordinary discoveries taking place in biological science. Entities such as systems, projects, businesses, and corporations whether held privately, owned publicly or run by governmental institutions operating at local, national, and global-level continue to benefit from the outset of these breakthroughs what is known today as industrial revolution 4.0. However, it is also true that these entities often have been adversely affected by these breakthroughs due to unforeseen risks.

The effects of these innovations have wide-scale ramifications (positive and negative) on humankind in all spheres of life - social, cultural, political, economic, and environmental as human beings participate in the entities. These spheres, as a conduit for participation in human activities, are exposed to risks arising out of environmental disasters, epidemics, and technical disruptions chiefly as a result of anthropogenic interactions. Even if these interactions are not meant to harm the entities mentioned earlier, the positive impact of human interference cannot be avoided. These human interactions are sometimes meant to do whistleblowing so that corruption, fallacies, or fraud can be disclosed.

For example, Edward Snowden took the lid off the US surveillance programs. There are many examples in which individuals’ interaction can be demonstrated that beget systemic risk for the better functioning of system/project/corporate governance, what is termed as ‘political action’ by Rice and Zegart (2018) in their book Political Risk. The difference between political action and ‘government action’ is that the former is centered on the individual action; whereas the latter is a state interference that generates a risk (tariffs, foreign policy, arms conflict, corruption, political instability, etc).

Because of the rise and spread of digital technologies, the state is no longer the only source of risk, rather a single person can pose an unprecedented risk with her/his social media activism that can bring a paradigmatic shift in the spheres we live and operate with implications either positive, negative or both.

Understanding systemic risk

The literature on systemic risk has been informed by scholars with a different set of approaches who have written on the subject matter of risk management. The information in this article has been retrieved from academic journals, online news articles, books, and data. A brief literature review on systemic risk is provided in the following section to survey the theoretical debate and themes on systemic risk offered by prominent scholars.

The themes within the subject matter of systemic risk are [a] scholarly views that have defined the concept and widened its scope (Bandt & Hartmann 2000; Renn & Klinke 2004; Schwarcz 2008; Hellstr?m 2009; Helbing 2013; Zigrand 2015) [b] expert articles on methods to measure, model and manage the systemic risk with quantitative methodologies (Lehar 2005; Brunnermeier & Oehmke 2013; Ellinas et al 2015; Acharya et al 2017) and by qualitative analysis (Hochrainer-Stigler et al 2019) [c] research and experiments aimed to apply the concept on project-specific case studies (Ackermann et al 2007) [d] research papers essentially written post-2008 global financial crisis (Battiston 2012; Haldane & May 2011).

In the following section, I provide a review of the literature on systemic risk concerning its definition, concept, and application with relevant scholarly work on the subject.?

The literature on the concept of systemic risk has predominantly defined the systemic risk from the financial prism (a financial market that includes the banking and insurance industry, investment portfolios, currency, capital, and derivative markets). Therefore, the notions of systemic risk were primarily held from the economic/financial perspective. This is evident as some scholars attempted to define systemic risk and its adverse effect on financial markets. For example, Bandt and Hartmann (2000) called systemic risk “the basic economic concept for the understanding of financial crises”.

In a similar vein, Schwarcz (2008) contextualized the definition of systemic risk as “the risk that (i) an economic shock such as market or institutional failure triggers (through a panic or otherwise) either (X) the failure of a chain of markets or institutions or (Y) a chain of significant losses to financial institutions, (ii) resulting in increases in the cost of capital or decreases in its availability, often evidenced by substantial financial-market price volatility”. Similarly, Acharya et al (2017) defined systemic risk as “the risk of a crisis in the financial sector and its spillover to the economy at large”.

From these definitions, it can be summarised that the impact of systemic risk is ultimately measured on the premises of financial crisis, economic shock, and spillover effects of both on the economy or market in general keeping in mind that systemic risk has negative, adverse, or inimical effects on the system, and these effects are resonated through financial losses. There is no doubt that systemic risk results in losses. But, the authors who have attempted to define the term have assumed the fact that the origin of systemic risk is merely technical. Whereas, the latest academic contributions by Hochrainer-Stigler et al (2019) inform us that while accepting the nature of systemic risk as a technical problem, human interactions and initiatives cannot be neglected while measuring, modeling, and managing systemic risk. They relate the systemic risk “to common notions of loss, dysfunction, or collapse as viewed from the perspectives of one or more well-defined human groups”. This definition widens the scope of systemic risk as it takes into account a singular event that an individual or a human group can pose as a direct threat to harm the system and its networks resulting in monetary or non-monetary (eg reputation) losses or both.

Indetermination, indecision, and responsibility are intrinsic characteristics of human nature, initiatives are taken and interactions are made, often leading to the likely occurrence of systemic risk. Hence, the authors argue that the systemic risk is not just a purely technical problem to be resolved from the natural-science perspective alone (which represents objectivity), but there is a need to accommodate the human-agency perspective (subjective interpretation) for solving systemic risk problematic. This is very crucial as a political action of an individual can pose a systemic risk and can precipitate cascading effects on the system and its network due to the technological advancements that have enabled nowadays for anyone to expose the fallacies in the system with lightning speed.

On a societal level, individuals, human groups, and society made up of them have an interplay of complex and dynamic interactions forming systems and interconnected networks at a macro level and sub-systems and networks at the micro level which translates into all domains of life. Therefore failures at the macro or micro levels of system and network have ramifications on each other that might heighten the total system collapse which is according to Helbing (2013) is the “risk of having not just statistically independent failures, but interdependent, so-called ‘cascading’ failures in a network of N interconnected system components”. This ‘risk systemicity’ (Ackermann et al 2007) has been captured by the OECD’s definition that engulfs the societal understanding and defines systemic risk as “one that affects the systems on which society depends – health, transport, environment, telecommunications, etc” (OECD 2003). These definitions not only further widen the scope of the systemic risk but also fix the gap left by the scholars who earlier situated the systemic risk within the context of a financial prism.

Conclusion

It is argued that systemic risk is no longer a risk just arising from technical issues/errors affecting only financial spheres but its impact is now extendable to systems and networks that are outside the purview of the financial sphere. The argument is truly applicable in the case of the current coronavirus pandemic where the effects of systemic risk are visible on all of us. So, we come to understand the concept of systemic risk that was situated in the realm of the financial/economic sphere to the point where an individual human action, besides technical error, is taken into account which translates into socio-political spheres.

References

Acharya, VV, Pedersen, LH, Philippon, T, Richardson, M 2016, ‘Measuring Systemic Risk’, The Review of Financial Studies, vol. 30, no.1, pp. 2–47.

Ackermann, F, Eden, C, Williams, T & S Howick 2007, ‘Systemic risk assessment: a case study', Journal of the Operational Research Society, vol. 58 no. 1, pp. 39-51.

Battiston, S, Gatti, DD, Mauro, Gallegati, M, Greenwald, B, Stiglitz, J 2012, ‘Liaisons dangereuses: Increasing connectivity, risk sharing, and systemic risk’, Journal of Economic Dynamics and Control, vol. 36, no. 8, pp. 1121-1141.

Bandt, OD & Hartmann, P 2000, SYSTEMIC RISK: A SURVEY, European Central Bank, viewed 15 March 2020,

< https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp035.pdf>.

Brunnermeier, M K & Oehmke, M 2013 ‘Chapter 18?-?Bubbles, Financial Crises, and Systemic Risk’, Handbook of the Economics of Finance, vol. 2, no. B, pp. 1221-1288.

Ellinas, C, Allan, N & Johansson, A 2016, ‘Project Systemic Risk: Application Examples of a Network Model’, International Journal of Production Economics, vol.0, no. 182, pp. 50-62.

Hellstr?m, T 2009, ‘New vistas for technology and risk assessment? The OECD Programme on Emerging Systemic Risks and beyond’, Technology in Society, vol. 31, no. no issue, pp. 325–331.

Helbing, D 2013 ‘Globally networked risks and how to respond’, Nature, vol. 497, no. pp. 51-59.

Hochrainer-Stigler, S, Colon, C, Boza, G, Br?nnstr?m, A, Linnerooth-Bayer, J, Pflug, G, Poledna, S, Rovenskaya, E & Dieckmann, U 2019, ‘Measuring, modeling, and managing systemic risk: the missing aspect of human agency’, Journal of Risk Research, vol. 21, no. 12, pp.1-17.

Lehar, A 2005 ‘Measuring systemic risk: A risk management approach’, Journal of Banking & Finance, vol. 29, no. 10, pp. 2577-2603.

OECD 2003, Emerging Risks in the 21st Century: An Agenda For Action, Organisation for Economic Co-Operation And Development, viewed on 31 March 2020, <https://www.oecd.org/governance/risk/37944611.pdf>.

Renn, O & Klinke, A 2004, ‘Systemic risks: a new challenge for risk management, EMBO reports, vol. 5, pp. 541-564.

Rice, C, & Zegart, A 2018, Political Risk: How Businesses and Organizations Can Anticipate Global Insecurity, Hachette Book Group, New York.

Schwarcz, SL, 2008 Systemic risk, Georgetown Law Journal, vol. 97, no. 1, pp.?193-250.

Zigrand, J 2015,’How can we control systemic risk?’, World Economic Forum, viewed 26 March 2020, <https://www.weforum.org/agenda/2015/08/how-can-we-control-systemic-risk/>.