Question

Clarify the distinction between institution-specific financial risk and systemic financial risk. What are the main limitations with the way that regulators measure and control for financial stability?

Answer 1

Please see the table below for distinction:

Sl. No.	Parameter	Institution Specific Financial Risk	Systemic Financial Risk
1	Definition	Financial risks specific to the institution; not applicable to all the players in the market; specific to one institution or a group of similar institution	Financial risks applicable to the entire system, i.e. to all the players in the market (applicable to the entire universe)
2	Nature	Diversifiable, predictable, and hence can be eliminated to a large extent	Undiversifiable, unpredictable, and hence can't be eliminated completely
3.	Also known as	Residual risk, non systemic risk, specific risk	Volatility risk, market risk
4.	Originates from	Uncertainty inherent in the institution and business environment	Uncertainty inherent in the entire system or market or universe
5	Examples	Regulatory changes like tax exemption, change in management, expansion into a new geography, introduction of a new product or service	Interest rate fluctuations, War, Recession, Economic expansion, Terrorist attacks, inflation

What are the main limitations with the way that regulators measure and control for financial stability?

• Some of the systemic risks are very complex and difficult to measure. Some of them can't be measured at all. For example risk associated with a world war, terrorist attack. Risks associated with interest rate fluctuations and inflation are very complex and dynamically changing. These factors induces limitation to financial stability measurement and control measure.
• Deployment of appropriate risk controlling measures through regulations - Financial institution capital is heavily regulated. Still the debate on "how much capital to hold" continues. Over a period of time, regulations have improved but they still need reforms. Capital requirement regulations are necessary but they are not sufficient to ensure stability
• Supervision by the central bank: this is good but then this curtails the flexibility of the financial institutions to do the business. This leads to extensive reporting and administrative tasks.