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The write up has an article of 1000 words on the following topic: When a steel company
goes bankrupt, other companies in the same industry benefit because they have one less
competitor. But when a bank goes bankrupt other banks do not necessarily benefit. Discuss this
statement from systemic risk point of view. Provide examples from the global and local
markets.
 Systematic Risk refers to risk or probability of chain reaction or break down of entire
system due to failure of either individual or multiple entities in the system. Systematic Risk in
banking system is evidenced by high correlation and accumulation of bank collapse in a single or
multiple nations or across the world. Such risk refers to an event which will have an impact on
entire banking, financial or economic systems. (Kaufman & Scott)

Banking system plays pivotal role in functioning of economies and failure of the system
has more unfavorable impact on entire economy which has much higher probabilities to spill
over to have larger impact across nations and thus lead to global financial crisies. The same is
not the relevant case when look from a perspective in case of an individual non banking firms
which are governed by company specific risk and has limited to negligible linkages to other
firms in the economy and hence does not lead to collapse of entire system unlike banks wherein
cumulative losses in one bank

For instance, in case of a steel company, let us assume Firm A, headquartered in Sydney,
which is a market leader, has major operations in Australia besides presence across many nations
and has been delivering sustainable growth resulting in better margins and hence higher market
share. However this Firm A has been running its operation by following a practice of very high
leverage on its balance sheet to finance growth and has gone overboard in expanding beyond
many nations to grab global market share. The company focuses on volume and hence plays on
economies of scale and operates on wafer thin margins. The second and third best Firm B and
Firm C and others are running its operation largely in Australia with limited presence in
international geographies. These companies are very low to negligible on leverage and are
focused on maintaining their margins. Even though Firm A has operations in multiple locations,
yet it has very high client concentration with more than 75% of business coming from barely five
clients who all operates in housing construction industry compared to its competitors who
considerably diversified players in respect to customers business profile. A sudden collapse in
demand in housing construction industry will have major impact on Firm As operations. Also
given higher leverage will lead to relatively considerable effect on Firm As profitability.
Continuous prevalence of such environment will lead Firm A more closure to bankruptcy.
However, this will have very limited impact to other players in the system with effect on only
those players who have large exposure to debt and housing construction sector. On the contrary,
the situation will become a boon for other players like Firm B, Firm C and others to grab Firms
A market share. The situation is relevant for any other non-banking industry and individual
collapse of an organization need not necessarily lead to collapse of entire system and in most of
the cases benefits other players in the industry at a price of the losing entity.

In case of banking industry, the failure of one bank seems to be harming the entire system
in style as there is a more likely hood case of crises spilling over to entire system in the nation
and some time even across the globe. The economic failure of bank happens when the business
sector or commercial industry estimates to accrue advantages through its operations lower than
the estimation of liabilities arising out of the same operations. In the event of such crises banks
will have fair chance to assume the failure by entities to honor their commitments provided by
such banks leading to major liquidity crises and hence rise in bad loans leading to collapse of
entire banking system and thus major economic crises. How banking system works is like this,
Bank B will borrow from Bank A to lend to Bank C which further lends to Bank D and latter
lends to final consumer who may be an individual or business sector firm. Failure on part of
Bank D, for any reason, to honor its liabilities due to Bank C will produce a loss greater than
Bank Cs capital triggering latter inability to honor its commitment to Bank B producing thus
loss greater than Bs capital triggering latter inability to pay back to Bank A and so on and hence
lead to full system collapse leading to full blown financial crises. The crises is not limited to
Bank Ds inability to pay back to C and so on, it may also be caused by an exogenous external
shock emphasized by third-party risk exposures among the units involved. In such cases, when
one unit experiences adverse effects from such shock, say major crises in business sector where
all connected units are over exposed to that sector or over exposure to sub-prime mortgages
across all entities, which have potential to generate sever losses, uncertainty arises over values of
other units also subject to adverse effects from the same shock and collapse of system. More
similar the risk-exposure profile to that of initial unit economically, politically or otherwise, the
greater are the chances of loss, and the more likely it is that participants will withdraw funds as
early as possible leading major liquidity problems and severe fundamental solvency problems.
(Kaufman and Scott).

The example of systematic risk can be observed from recent financial crises of
2008 09, the most severe since 1930, which had its origins in the United States housing market.
The U.S. house prices began to rise far above historical levels since late 1990s driving major
investment demand in the sector. Supporting this demand, the considerable lower interest rate
scenarios in the US led to major demand for mortgage loan which banks went over board to lend
to borrowers, in lieu of growth, without conducting adequate due diligence on their credit
worthiness leading to major spurt in sub-prime loans. Not only this, in order to gain major
benefits from rising house prices, investment banks were rewarded heavily who come up with
exotic derivative products with underlying sub-prime loans as securities and in many cases
without any underlying securities. Banks further topped up their loan book by taking heavy bet
on such exotic products which hands within the banking industry multiple times with same
underlying security or house. After several years of rapid growth and profitability, banks and
other financial firms began to realized losses against their investments either in houses, sub-
prime loans towards such houses, or exotic derivative products underlying such sub-prime loans
or houses or in related securities in second half of 2007 when housing prices collapsed like a
pack of cards. Those losses triggered full blown financial crises when banks 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 across major banking institutions like
Bear Stearns, IndyMac Federal Bank, the Federal National Mortgage Association (Fannie Mae),
the Federal Home Loan Mortgage Corporation (Freddie Mac), Lehman Brothers, American
International Group (AIG) and Citigroup kept entire financial markets on the edge throughout
much of 2008 and 2009. Spurt in global commodity prices especially crude oil driven by again
speculative demand led to major inflationary pressure across the globe leading to deterioration in
global consumer demand and rise in input prices and hence created major impact on business
sector operations which led to fall in profitability and hence major job losses. This further
created problems in the banking system and hence added to crises as the mortgage borrower
were unable to honor their bank and credit card payment obligations due to loss of job and hence
income. This financial turmoil was the major reason and primary cause of economic recession in
2007 which started from the U.S and spilled over to entire world. This is clear example of
systematic risk and how it impact the global banking system. (Bullard).
References

1. George G. Kaufman and Kenneth E. Scott. What Is Systemic Risk, and Do Bank
Regulators Retard or Contribute to It?
2. James Bullard, Christopher J. Neely, and David C. Wheelock. Systemic Risk and the
Financial Crisis: A Primer