Systemic crisis, systemic risk

Liquidity squeeze, credit crunch,
domino effect, bankruptcy cascade


A systemic crisis is a domino effect in which a financial trouble spreads
between institutions and markets until it affects the whole monetary
and financial system with dire global economic consequences.

Falling together from the money cliff

Definition

Economists call systemic risk and systemic crisis 
extremely danger destructive troubles that menace (risk) or
affect (crisis) the whole global
sous financial and monetary
system.

Such cataclysmic avalanches can entail
  • With dire negative effects on the whole economic system 
(trade, production, spending, employment, ...)
as we live in an era of fast and easy communications in which
those economic, and financial systems (not to forget the
political aspects) interrelate globally.

Cause and process: killer dominoes

A systemic financial or monetary crisis would result from a "domino
effect"
in which the collapse of an important financial institution
(bank, investment or pension fund, insurance company...
) spread to all
the worldwide financial and monetary system.
This contagioncontagious "great plague"  is not pure fiction. it is based on
known economic / financial mechanisms.
Some of the faulty elements, still far from fully repaired, have been
activated in the
2007 financial crisis and its aftershocks.
 
Here is the scenario of what can follow an initial collapse
that is not urgently  contained
(usually by injecting public money, ...if governments and central banks
are
not in dire financial situations themselves).
  • It can bring huge losses to other institutions
which have financial relations with the deceased or comatose
one(s).

Those risky links can be cross
deposits, loans, settlement
accounts, investments and other financial contracts and
instruments.
  • It would cause public averserepeal distrust towards those institutions.
In such case people withdraw their money or sell their financial
assets (and their real estate if they cannot meet their loan
charges).
This creates a
liquidity liquidity squeeze with:
      • more asset sellers than potential asset buyers,
      • less bank deposits in banks
      • also less money available for credit, and for markets.
As all those cash starving institutions have, as seen above, financial
network cross-links they would have problem to repay one another.
=> It would lead to a cascade of bankruptcies.

The surviving institutions would prefer - so as to escape the illiquidity
contagion -
to keep or hoard safe and liquid assets rather than to finance
their customers.


We have here the full "credit crunch" that endangers economic
activities
.

As investors (and customers) feel poor impoverished by the
asset price falls (or by hyperinflation, depending on the type of crisis),

they would
put a brake on their spending, another contribution to the
economic regression.


Last but not least, States (and the central banks) might be
caught into the
imbalance spiral (the section below details that
aspect),
because of:
      • Previous lax fiscal and monetary policies,
      • The cost of the financial institution rescues,
      • And the budgetary consequences of the economic recession
  • It might at the end, in the worst case, make the whole global monetary
    or financial system
    , some leading central banks included, crumble
    (with dire economic incidences), whence the "systemic" word.

    Can States be at the origin
    of a systemic crisis?

    The systemic risk shown above is chiefly the one attributed to financial
    institutions. But it can start or spread elsewhere.

    There is the risk of a worldwide liquidity crisis, with dramatic implications
    for foreign exchange markets,
    the sovereign bond market, and the world
    economy, if a leading country or several large ones default on
    its/their sovereign debt.


    A State bankruptcy hypothesis that can extend worldwide is
    nothing theoretical as nowadays
    • Some countries already went bankrupt or near bankrupt,
    Some had to be rescued in the last decades (Thailand, Mexico,
    Argentina).
    Others (Iceland, Dubai, Greece, Hungary, Ireland, Portugal,
    Spain, Cyprus...) either encountered recently the same fate
    or are on the cliff's edge.
    • Some major ones are on the tightrope
    They experience unprecedented budget deficits and foreign
    debt.
    (this includes the USA and its ocean of public debts,
    federal and local)

    seems gaining ground.
    • Central banks took dubious assets in their portfolio
    (subprimes, sovereign debts...)
    for being asked to contribute to the general rescue
    , via
    very low
    refinancing interest rates and with debt purchases, so
    as to relieve the financial stress in a first phase.
    It seems a miraculous move, but it is a potential source of new
    uncertainties, not only about how safe are those institutions but
    also on the value or the money they issue.
    • Of course three other key other financial institutions
    that run the same risk because of sovereign debts (and in some
    cases other dubious assets) in their portfolio

    * commercial banks (as they participate in creating and
       storing money in deposits, and use some refinancing from
       central banks),
    * insurance companies
    * investment funds

       (some of them seen as "shadow banks")

    Details and proposals

    The crisis watcher kit.

    => This danger of a systemic crisis due to financial institutions is
            detailed

    => What could be done to avoid such crises is proposed

  • => As for the risk related to State defaults, some hints on how it
    could evolve and how to adapt the World economic and
  • political governance to limit its effects can be found in
  • two articles :
  • => The risk of a global monetary collapse, and the ways to face it,
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    M.a.j. / updated : 08 July 2015
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