Systemic risk is a risk that is posed to the entire market, financial system or the economy, as opposed to a risk faced by an entity or an investor. In order to prevent its impacts, governments bail out those financial institutions that are considered as “too big and risky to fail”. Consequently, the shareholders of the big institutions gains if the risk pays off, while the government bears the cost if the institution goes wrong.
This creates a moral hazard; the institutions become government-dependent so as to gain the competitive advantage. The governments may also impose regulations to institutions such as banks in order prevent systemic risks. However, since the banks cannot give credits where the risk is high, the insurance sector would take over such deals, thus migrating the systemic risk from one sector to another. This proves that in order to protect against the risk, the government has to sponsor institutions from all sectors.
Financial institutions are encouraged to move towards unlimited liability as an effort of lowering systemic risks in this sector. This means that they stop depending on the governments’ bailout; they rather solve their liquidity issues when a crisis evolves. Contingent capital is a mandatory amount of claims that can be converted into equity when certain predefined harsh conditions are met, such as systemic risks or bank-specific threats.
By issuing contingent capital, financial institutions are able to convert these securities into stock to increase their capital buffer, thus minimizing the possibility of capital shortfall and costly funding in stressful times. Living wills are the resolution plans prepared by banks and other financial institutions; that explain how they would be safely wound down in case of failure-what the bank would do to ensure it continued to maintain adequate capital and liquidity. They focus on solving the bank’s specific problems. This helps the bank and the authority to decide on the way forward in times of firm-specific crisis and identify the obstacles that may be potentially removed to resolve the crisis.