Introduction

Risk is involved in every event, project, or system. It can never be eradicated entirely, but it can
be reduced to a minimum level. Even the most sophisticated and carefully planned schemes face
troubles due to the presence of the element of risk. Like different projects, entire systems can
succumb to risks. Systematic risk is mostly defined as an event like economic turbulence,
organizational failure, which give birth to chain reactions and consequently become the cause of
the system's failure. At the least, the systematic failure can lead to loss to a financial institution
or market failure, but whatever the consequences are, the risk impacts the institution or the entire
market or both.

This paper will look into the systematic risk present in the financial market and institutions like
banks. How are they managing it, and are they successful in managing it? If there are
shortcomings, what are they, how much they can be disastrous, and how can they be mitigated?

Financial institutions like banks are the capital providers to a market. A failure in this sector can
cause a great deal of problems for the rest of the market because being the sole provider, the
determination of prices and other costs are totally dependent on it (Schwarcz, 2014). It will drive
away from the capital in society and eventually results in an increase in price. In financial jargon,
such types of events are called cascading effects or events. One event causes, another and that
will go further down, eventually hitting pretty much a lot of segments in the society. The ripple
effect of the systematic risk and its probable result can bring down an entire economy on its
knees, just like the financial crisis of 2008 (corporate finance institute). If the situation is
narrowed down to the bank, the systematic risk involved therein is pretty much clear. Banks'
normal practice is they do not keep all their customer's cash in their account all the time. They
lend it out to people who need an keep a particular amount of cash in their account, so at any
time, if a customer needs his/her cash back, they can provide it to him/her. But in a situation
where all the customer walks in at one time and demands their money back, the bank does not
have all the money to go bankrupt and ultimately fail. But the systematic failure becomes
realized when all the banks face defaults. In the real world, all the banks are interconnected, and
they depend on each other to lend money to the lenders and share the capital their customers
have deposited. So once one bank goes bankrupt, it will lead to a chain of events, resulting in the
system's failure.
Literature review

Up till 2008, financial institutions were very much confident about the system. The amount of
money the financial institutions have lent out to build empires and open new business ventures
on a contingency base was way more than what the institutions could confidently stand. In the
financial meltdown of 2008, almost two-thirds of investor's money got drowned due to the
systemic model. The systemic risk present in the financial institution was not accurately
measured (Lin, Edward M.H., et al., 2008). After realizing the dramatic effect of systematic risk
involved in financial institution regulator took the issue seriously and sat down to lower the level
of risk and the potential solution in case of another failure. Committees like Basel Committee on
Banking Supervision put their head together and suggested policies to encourage these
institutions' solvency and develop potential preventing methods. In addition to the suggested
policies, the Committee encouraged the regulator to oversee the financial institutions to promote
stability strictly. According to Investopedia the financial meltdown of 2008 has triggered a
number of legislations and the creation of agencies that aimed at regulating the risk involved in
the financial institutions and agencies to check up on the institutions regarding the compliance of
the regulations. At that time, many agencies like TRAP, FSOC, and CFPB were created, but with
the passage of time, authorities forgot the crisis and eventually winding up of neglect of the
agencies created for overlooking the financial institutions.

Fox Justin (2013) while writing for the Harvard Business Review, the financial institutions'
failure in 2008 was almost near the great depression unless the government has jumped in to save
the market. Capitalism believes that the market adjusts itself, keeping in check on supply and
demand, but this does not work all the time, just like the crisis of 2008. According to Fox, there
have been three major shifts after the economic shock, “(1) Macroeconomists are realizing that it
was a mistake to pay so little attention to finance. (2) Financial economists are beginning to
wrestle with some of the broader consequences of what they’ve learned over the years about
market misbehavior. (3) Economists’ extremely influential grip on a key component of the
economic world—the corporation—may be loosening”. If the governments have not come out to
save the banks, the result would have been much worse, and even today, we could not come out
of it. The dynamics after that changed completely in the financial market globally. Fox blames
"corporate governance" and "risk management" as the cause of the crisis. These were the main
ailments causing pain in the financial market for many years, which showed their effect in 2008.
In the post-crisis business world, governance and risk management took effective measures to
mitigate the loss and put in place strict rules and compliance costs to ensure the rules'
applicability. Customers, investors, and regulators in the after-the-world financial institution can
easily hold accountable the financial institutions that are not taking averse risk measures. Now,
the risk management is responsible for a failure, and the board of a company, the chief executive,
and other heads of a business are also responsible for any failure stemming from poor financial
risk management or non-compliance with the rules. According to Irving Fisher and Keynes, the
amount of inflation can trigger a financial meltdown coupled with the irrational investment of
investors in tough times, but the help of the government can lower this. According to Tett,
Gillian (2018) the failure of banks in 2008 was due to the greediness of the banks, as they were
making more and more money. On the other side, no one, neither the government nor the
regulator, saw this as a potential threat to the economy. So, what happened was the bank took so
much money in and lend it to entrepreneurs that it drive everything out of the financial market.
For the most part, this was because of the confidence in the free market and the strength of the
economy. But then investors loos their trust when the prices in the real state start falling. They
start pulling out their money, which eventually ends up in default for many banks and then the
government's chipping. The effect of the crisis cascaded down to rising prices for everything.
People became poor, the cost of living skyrocketed, and meals become difficult for many people
to get two times.

The Systemic Risk Council, which is overlooking the financial markets, is a body constituted by
the US and European leaders. This body suggests and encourages reforms in the financial market
from time to time, especially in the areas of "bank capital requirements, money market reform,
and funding for financial regulators."

Systematic Risk in Financial Institutions

Financial institutions like banks are essential to run the capital market. They are the primary
source of money to run the market. A failure of a great number of financial institutions can cause
serious problems to an economy. This can better be understood by the crisis of 1929 when the
stock market crashed, and the bank depositors rushed to banks to withdraw their money. As
banks do not keep all the money in their closet, it causes bank failure, and one bank failure leads
to many other banks' failure, which caused the liquidation of many companies and bankruptcy.
This failure of a bank one by one and eventually failure of the majority of the banks is a
systematic risk (CFA Institute). But this has been lowered to a certain level by inserting
intermediaries and other means of generating capital. Many businesses generate their own capital
without consulting through the intermediaries, making them accountable and taking steps to
counter the systematic risk. Any eruption caused in the system spread through different channels
and lower the impact on the central banking channel (McKensey and Company). After the great
depression and then the financial crisis of 2008 makes the economist and financial analysts think
that, after all, human beings are not totally rational. They devised theories to overcome the risk
in the market by spreading the investment portfolio. In the modern world of finance, an investor
can protect himself or herself by participating in different investment opportunities. The random
selection of investment portfolios spreads out the risk and lowers its impact. Long Term Capital
Management is another offshoot of financial management. But it has also faced failures, so if the
failure of the Long Term Capital Management and the Banking Institutions are read together, it
will help in developing sustainable solutions. In both these markets, the failures are kicked off by
the failure of the individual institutions, which cause a chain reaction due to the close
relationship within the system and their interdependence. The interbank borrowing in the
banking system and derivative based hedging in the Long Term Capital Investment is the
systematic risks involved. Further, these are linked to other institutions which work as adding
fuel to the fire in times of crisis. The risk associated with financial institutions and the market
should not be studied or observed separately. They both are the key player in managing risks.
The systematic risk associated with these institutions can better be understood through the
intermediaries. The type of study this paper is suggesting can be useful in the sense that it can
give us a better perspective to study the failure of these intermediaries, which can significantly
impact the cash flow in the market. Hedge funds are another very risky intermediaries revolving
in the financial market. The risk which hedge funds contain is much more worse than any other
financial institution. The systemic risk in hedge funds is largely because of these funds' manager
is very passionate about securing profits and quick returns, which make them vulnerable and
expose to risks easily.

According to scholars, financial risk regulation is necessary for an efficient and smooth running
of the financial market. So, efficiency is the focal point of any rule and regulation revolving
around the financial institution. The main themes involved in the regulation are protecting
investors against any fraud and abuse and maintaining healthy competition in the market, and
correcting market failures. In the absence of these regulations, the externalities present in a
systemic risk cannot be prevented. The rationale for presenting such a theory is that the
participant in the financial market participant for their won interest they do not think about the
system as a whole. They will try to protect themselves before protecting and safeguarding the
financial market. The final result which stems out of this situation is a tragedy of commons. The
participants are involved in a practice that maximizes their profits which can not be achieved
without costing the economy as a whole. In the future, to avoid systemic failure, there are a
number of proposals put forward by scholars which can potentially deal with the systemic risk to
a great extent. The first, to avoid a systemic failure, it is essential to avoid panic (Friedman &
Schwartz, 1963). What happens is whenever there is an indication that there is a chance of failure
of the market or the market is going slow, investors and creditors rush to banks and withdraw
their deposits. This unnecessarily puts more burden on the already struggling system. If the panic
is controlled in any potential market failure, the systemic crash can be avoided ab initio.
Financial panic is the key to systemic failure, which gives birth to many other failures because of
its chain. Economists usually refer to this kind of panic as "monetarist" because this banking
panic causes monetary contraction. The second element in controlling a systemic failure is the
requirement of disclosure. This is the primary requirement of financial regulations. Disclosing
the risk involved in the market practices spreads the knowledge of the risk due to asymmetric
information due to power imbalance in the market. This makes the risk known to all, which
makes everyone cautious and act accordingly, hence risk can be minimized. The third regulatory
perspective to decrease the risk of financial failure is the limit of financial exposure one bank can
get from another. When large institutions borrow money from other banks without any
limitations, they become extremely vulnerable in the time of crisis, which can cause a completer
meltdown of the economy. By limiting the financial exposure, the risk can be spread out. The ad
hoc approach is another way to minimize the chance of a financial market failure. It balances out
the cost and benefit of taking a risk. Finally, market discipline can regulate the systemic risk
present in the financial market. Such type of regulation is said to be efficient because it does not
need costs to regulate. In a perfectly competitive market, regulation is not necessary, but the real
market is not perfectly competitive it constantly needs external intervention to avoid any failure.
Conclusion

It can be concluded from the above discussion that although systemic risk cannot be eliminated
completely, it can be reduced to a minimum level by putting in place rules and regulations.
Neither the participant in the financial market are completely rational, nor the financial system is
perfectly competitive. Participants in a financial market always seek to maximize their profits
without taking into consideration the risk involved in the system as a whole. On the one hand,
this is largely because of the asymmetric information between the financial institution and its
customers. When the risk is not known to the participant, they act always to benefit their own
individuality. If the information asymmetry is eliminated by disclosure, then the systemic risk
can be spread out and can be minimized. At last, lessons should be learned from the economic
meltdown of 2008, which exposed the vulnerability of financial institutions. Banks and other
financial institutions must be regulated in order to avoid any future economic catastrophe. The
reason for emphasizing systemic risk regulation is that it is a chain of events that affects
everything in an economy.
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