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| Question | Answer |
| Systemic Risk | Risk that the entire financial system fails, causing a collapse of the real economy. It is caused by interlinkages and amplified by the inherent pro-cyclicality |
| Origins of Systematic Risk | Arises from inherent structural weaknesses: - pro-cyclicality - information asymmetry - interdependence/interlocking exposures/indirect exposure - perverse incentives |
| Money Aggregates | M0: paper money & reserves at CB M1: M0 + current accounts M2: M1 + savings accounts (close money substitutes) M3: M2 + large time deposits, institutional money market, short-term repurchases |
| Fractional Reserve Banking | Limitation for banks in form of reserve requirement δ with the CB with the purpose of creating higher forms of money out of lower forms. The higher the required reserve ratio, the lower the money supplier |
| Pro-Cyclicality | A process that is positively correlated with the economic cycle, e.g. bank capital, leverage, encouraged by risk-weighted capital, mark-to-market accounting and financial regulations |
| Firesale Externalities | |
| Asset growth/leverage relationship | Households: negative relationship → the richer, the less leverage, (payback of mortgages/increase in house prices reduce leverage Broker-dealer: positive relationship → Equity increases on a constant rate on average, translating into a tendency to continually increase leverage |
| Information Asymmetry | Agency and trust problems occur due to the information asymmetry present between counterparties and banks, which can result in bank runs or the seizure of new transactions and thus an evaporation of liquidity |
| Moral Hazard | Perverse incentives created by policies or financial regulations, causing economic agents to act in a way that is risk-increasing to the economy, e.g. bail-outs or lenders planning to securitise their loan books (less incentives to monitor the loan quality) |
| Why are Russia, Greece & Argentina no good examples of a systemic crisis? | Fiscal problems, corruption, FOREX problems and structural real economy problems caused difficulties, not financial system |
| Policy intervention to prevent systemic crises | - not easily eliminated without restricting risky activities/reducing size of financial system → adversely affecting real economy - modern society can't grow without sophisticated financial system - find appropriate risk-return combo - less "national champs" |
| Role of financial institutions in creating systemic risk | - due to competition, short-term outlook & profit-maximizing behavior - risk is hidden in boom times [financial instability hypothesis, Minsk 1992] -tendency to extrapolate stability & liquidity into infinity, undermining stability and eventually forcing violent repricing |
| Role of government in creating systemic risk | - moral hazard: bail outs incentivize more risk-taking -direct source of risk: wars policies might have unforeseen adverse consequences (risk-shifting in more opaque banking areas, increasing risk) - do not consider systemic impact of policies |
| Relationship between M1 and monetary base | M1 = γ * M0 = 1/δ * M0 → the higher the required reserve δ, the lower the money multiplier γ |
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