Edited by John Raymond LaBrosse, Rodrigo Olivares-Caminal and Dalvinder Singh
Chapter 2: The Nature of Systemic Risk
Jack Selody1 2.1. INTRODUCTION The fragility of the world financial system after the 2007 meltdown of the US subprime securities market was surprising. Policymakers had been working diligently in the years prior to the shock to strengthen the robustness of the infrastructure connecting major elements of the system. Many national large value payment systems had been risk proofed.2 The Continuous Linked Settlement (CLS) bank had recently launched, which risk proofed large value foreign exchange transactions in major currencies.3 Bank deposit insurance was widespread and deposit-taking institutions were heavily regulated.4 Based on previous crisis experience this risk proofing should have made the world financial system robust even to large shocks and prevented it from going into crisis. Indeed, the newly riskproofed elements held up well during the crisis. The episode reminds us that modern financial systems are complex and not well understood. Not surprisingly, the crisis triggered an impetus for regulatory reform that ranges from proposals to strengthen existing controls to calls for a paradigm shift. At issue is how best to protect against systemic risk. Achieving this objective requires a good understanding of the nature of that risk. In this chapter I look beyond the details of the recent crisis to ask: what constitutes the nucleus of a modern financial system and what makes it vulnerable to failure? I argue that the nucleus is the cluster of financial markets and supporting infrastructure that coordinates the activity of financial institutions. The principal systemic risk is the fragile liquidity of these core...
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