Systemic+Risk+and+the+Financial+Crisis--A+Primer+2009

Systemic+Risk+and+the+Financial+Crisis--A+Primer+2009 -...

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FEDERAL RESERVE BANK OF ST. LOUIS REVIEW SEPTEMBER/OCTOBER, PART 1 2009 403 Systemic Risk and the Financial Crisis: A Primer James Bullard, Christopher J. Neely, and David C. Wheelock How did problems in a relatively small portion of the home mortgage market trigger the most severe financial crisis in the United States since the Great Depression? Several developments played a role, including the proliferation of complex mortgage-backed securities and derivatives with highly opaque structures, high leverage, and inadequate risk management. These, in turn, created systemic risk—that is, the risk that a triggering event, such as the failure of a large financial firm, will seriously impair financial markets and harm the broader economy. This article examines the role of systemic risk in the recent financial crisis. Systemic concerns prompted the Federal Reserve and U.S. Department of the Treasury to act to prevent the bankruptcy of several large financial firms in 2008. The authors explain why the failures of financial firms are more likely to pose systemic risks than the failures of nonfinancial firms and discuss possible remedies for such risks. They conclude that the economy could benefit from reforms that reduce systemic risks, such as the creation of an improved regime for resolving failures of large financial firms. (JEL E44, E58, G01, G21, G28) Federal Reserve Bank of St. Louis Review , September/October 2009, 91 (5, Part 1), pp. 403-17. International Group (AIG), and Citigroup—kept financial markets on edge throughout much of 2008 and into 2009. The financial turmoil is widely considered the primary cause of the eco- nomic recession that began in late 2007. As individual firms lurched toward collapse, market speculation focused on which firms the government would consider “too big” or “too connected” to allow to fail. Why should any firm, large or small, be protected from failure? For finan- cial firms, the answer centers on systemic risk . Systemic risk refers to the possibility that a trig- gering event, such as the failure of an individual firm, will seriously impair other firms or markets and harm the broader economy. Systemic risk concerns were at the heart of the Federal Reserve’s decision to facilitate the T he financial crisis of 2008-09—the most severe since the 1930s—had its origins in the housing market. After several years of rapid growth and profitability, banks and other financial firms began to realize significant losses on their investments in home mortgages and related securities in the second half of 2007. Those losses triggered a full-blown financial crisis when banks and other lenders suddenly demanded much higher interest rates on loans to risky borrowers, including other banks, and trading in many financial instruments declined sharply. A string of failures and near- failures of major financial institutions—including Bear Stearns, IndyMac Federal Bank, the Federal National Mortgage Association (Fannie Mae),
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This note was uploaded on 10/02/2011 for the course GEOGRAPHY 101 taught by Professor Vancura during the Spring '08 term at Rutgers.

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Systemic+Risk+and+the+Financial+Crisis--A+Primer+2009 -...

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