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Why regulate systemic risk

There are several reasons that would necessitate the regulation of systemic risk. Systemic risk may be driven by many factors and not only by the size of the collapsed firms. The failure of one firm may cause recurrent failures in other firms, however, this would only be so if the other firms and sound financially stable. Therefore, a failure can only be deemed as a systemic risk if it would cause failure in other component key firms of the financial system. In this case it would be necessary to regulate systemic risk and lower the probability of an economic failure.

Firms or financial institutions’ externalities may be interconnected and each firm’s systemic risk would be a negative effect component that firms may have on the systemic risk. Individual firms can be moved to prevent their own collapse but not the collapse of the financial system in its entirety. In such cases a firm may take into consideration the option of holding large amounts of non-liquid securities, concentrate its systemic risk into specific asset holdings such as the subprime? based assets, or puts high amounts of control on its books in order to increase extra returns.

The firm’s incentive would be to administer its individual risk/return swap and not at all consider any possible spillover risk it may inflict on other similar financial institutions. If one firms failure triggers liquidity cyclical movements also referred to as liquidity spirals , then the risk spillover would have began, leading to dejected and deteriorating asset prices and an aggressive funding situation, that may cause a dragging down of other firms leading to further price degeneration and money illiquidity.

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This degeneration would then turn into lack of liquidity abilities by many markets and economies and an eventual collapse of the entire system. Other externality may be stem from the failed firms rescue attempt by larger and more stable firms. Whenever a financial institution fails, there are larger financial market players that may come in with the intent to buy the failed institutions or to take over most of the remaining failed institution’s assets and take up the lending processes and related undertakings formerly handled by the failed entity.

If a chain of institutions fail at the same time, then real losses may be experienced if they all cannot be rescued at the same time. To avoid this from occurring incentives can be given to financial institutions, especially small ones that are vulnerable to failure, to motivate them to handle this negative externality internally. By doing so, they would then reduce the impact of their failure on the overall systemic risk.

In addition, inherent government guarantees can necessitate regulation of the financial systemic risk as they create moral hazards if they maintain the false comforts that either they are too large or stable or highly leveraged to fail, too interrelated to fail exposing the firm to high levels of exposure to counterparty risk, and sometimes when firms idealize the notion that the may be too many to fail hence taking on high levels of risk that would proportionately translate to higher systemic risk.

Moral hazard is highly severe in such cases and regulators, with significant costs accompanying the decision to go ahead with the bailout, often reflecting a high proportion of the GDP of economic entities concerned. In all these cases, viability of strict regulation of the financial systemic risk are then realized. All of the above underlying reasons demand all regulators’ application of wisdom and caution in regulating systemic risk rather than regulating each institution’s risk of collapse individually. Financial institutions are frequently regulated to edge their failure effect or any significant externality they may initiate.

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