System risk in the context of current crisis

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Financial crises are preventable occurrences. As Jorion (2000) cautions, “Financial disasters still occur – witness Asia’s 1997 market turmoil, Russia’s 1998 default, and the near collapse of Long-Term Capital Management (LTCM) – as institutions either fail to see or, in some cases, completely ignore easily recognizable hallmarks of impending financial disaster. ” James A. Dorn, in his article, “International Financial Crisis: What Role for Government? ” also emphasizes that: If investment flows are to continue to emerging economics, a new means must be found to bring predictability to the resolution of unsustainable sovereign debt.

But will this be imposed by flat or evolve though market forces? Will the IMF return to its original mandate or extend its command and control over developing nations and markets? … The outcome will determine the wealth and well-being of the globe’s developing countries (p. 1). Analysis and adequate enactment of policies is a clearly unavoidable “must do” to ensure reduction of future reoccurrence of multiple failures caused by interconnectivity of banks and financial institutions.

“In order to meet the objectives of high, stable growth and low, stable inflation, monetary policy-makers must insulate the real economy from financial-sector shocks. That is, central bankers strive to keep credit-market disturbances problems from spreading to the economy at large” (Felton ; Reinhart, 2008, p. 33). Current financial crisis may have been triggered by a series of unregulated or inadequately regulated systemic risks. “Systemic disturbances can erupt outside the international banking system and spread through capital-market linkages, rather than merely through banking relationships” (Schwarcz, 2008).

Most crises in the past such as LTCM and S;L related crises can be attributed to a credit boom and default risk. Lack of improvement on regulation policies enhances reoccurrence of financial crises. The current crisis is not exception. “Institutional systemic risk and market systemic risk therefore should not be viewed each in isolation. Institutions” ((Schwarcz, 2008). Though the Russian default may have seemed as a small fraction of the debt global debt, its impact cannot be ignored. The default triggered a system risk that formed the beginning of the failure of Long-Term Capital Management (LTCM).

In the events that led to the failure of the entire systems, current interconnectivity of financial institutions and increasing rash withdrawals of deposits due to fears of market failure, regenerate in the form of one firms financial failure that then sparks spillovers to directly and indirectly interconnected firms. Accumulation of debt without planned repayment creates a non-coverable liability that created the default risk. Portes (1998) discovered; As Common factors are de facto exchange rate pegs to the dollar, which resulted in overvaluation and large current account deficits, and excessive private sector foreign borrowing.

But the idiosyncratic factors are at least as important: Thailand’s central bank took forward positions that depleted net foreign reserves, and its finance companies accumulated massive non-performing loans; Indonesian industrial structures favor a particular political force but are inefficient; Korean banks borrowed too much abroad on short maturities, and the Korean industrial sector is exceptionally highly leveraged (p. 3). Through different market and financial system failures a financial crisis was fueled and now threatens the global economy.

Increasing deterioration in the macroeconomic risks can be traced back to the increasing economic downturn. Financing trades has decreased hence creating a decrease in global trading especially in emerging or new markets. As the economy experiences a downturn, the inability to certainly evaluate its impact and financial system stress is increasingly leading to higher and higher credit risks. Vast loss of jobs creates a strain on household budgeting which in turn impacts the public purchasing power. Demand for goods and services slow down creating liquidity challenges with no cash flow in the market.

A failing trading system is a failing financial system. In the case of the current crisis cyclic occurrences of decreasing purchasing coupled with default risk, creates a cycle of financial losses that then cripple the economy. The economies backbone can only be strengthened by its ability to turn liabilities into assets and creating profitability. If this lack in the financial system, there is increased systemic risk that, if not, regulates by strong policies, causes a system that emulated past failures close to the Great Depression.

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