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Contagion


by daniel archibald

 

Whilst seemingly being very similar, the words 'systemic' and 'systematic' often mean quite different things. For example, a common term used recently, 'systemic racism', is often confused with 'systematic racism'. In this regard, the former relates to different outcomes for people based on their race, which are generally not due to any explicit system rules or controls (i.e. inherent biases). The latter, on the other hand, would describe a social system that has prejudicial functions embedded into its processes. 

In finance, the terms 'systemic' and 'systematic' are used as a way of describing risk, and again, mean different things. Systematic risk is the more common of the two, and relates to the risk inherent in an asset's value that is attributable to the system. For example, the systematic risk of a share is the risk inherent within all shares, which is based upon the risk factors to which all businesses are exposed (such as the risk in the economy, or the risk of changing interest rates). The other type of risk to an asset's value is its unsystematic risk, or the risk NOT attributable to the system. This is the risk in an asset that arises from its own characteristics and not that of the system. As such, it is often referred to as idiosyncratic risk. 

Systemic risk, on the other hand, is the risk that a system may fail due to a system-wide contagion. This is where the failure of one business, leads to the failure of another and another. The domino-effect that can ensue is similar to a disease spreading and is due to the high interconnectedness of the business community. 

A common example of systemic risk relates to the banking industry. Most banks have numerous open financial positions with numerous other banks, including short-term lending and currency derivatives. This creates a web of connections that support all banks at once. In the event of bankruptcy of one bank, the whole web might start to crumble, taking down one bank after the other. This may be due to loans owed by collapsing banks or profitable derivative positions that will now go unpaid. 

This type of contagion can affect in system of business or marketplace that has a high level of mingling. One remedy for this, which we saw during the 2008/09 global financial crisis was self-imposed isolation of banks - otherwise known as a 'credit crunch'. This, of course, had devastated effects on the broader business community who needed the banks to continue to function. Governments and regulators might also impose 'circuit-breaker' mechanisms to stop the bank dominoes from falling. 

Overall, however, the growing interconnectedness throughout the world will only increase the risk of financial contagion (and health pandemics). Whilst it is only a matter of time before a significant event snowballs into a systemic risk, it is critical that we learn from the past and move quickly to adopt proven measures.

 

LBW Wealth Management is an Authorised Representative of Wealthsure Financial Services Pty Limited AFSL 326450

This article has been prepared by LBW's investment committee based on its understanding of current regulatory requirements and laws. It is not considered advice and provides general information pertaining to our ideology surrounding future asset allocation strategies. It does not take into account each client's individual objectives, financial situation or needs. If you would like to know how LBW's understanding of the current environment impacts on your portfolio please contact a Financial Adviser and to discuss your options or before making an investment decisions. 

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