The financial crisis has exposed the weaknesses in national and international economies, the disruption of the financial systems all over the world. The aim of this paper is to point out the importance of systemic risk management in the European Union (EU). Structured on two parts, the study presents the evaluation methods of the systemic risk in the mentioned area and the main proposals for the financial stability reconstruction. To conclude, deep reforms are needed: an adequate financial regulation and supervision, the evaluation of the performance over time, new rules for improving capital and liquidity and a better communication between institutions in order to prevent and neutralize possible distress.Systemic risk; financial crisis; European Union

Avadanei, Anamaria

Ghiba, Nicolae

English

Research Papers in Economics

EVALUATING AND MANAGING SYSTEMIC RISK IN THE EUROPEAN 
UNION 
   
Avadanei Anamaria, Ghiba Nicolae 
Doctoral School of Economics, 
“Alexandru Ioan Cuza” University of Iasi, Romania 
anamaria_avadanei86@yahoo.com 
ghiba.nicolae@yahoo.com 
 
Key words:  
 Systemic risk, financial crisis, European Union 
Abstract: 
The  financial  crisis  has  exposed  the  weaknesses  in  national  and  international 
economies, the disruption of the financial systems all over the world. The aim of this 
paper  is  to  point  out  the  importance  of  systemic  risk  management  in  the  European 
Union (EU). Structured on two parts, the study presents the evaluation methods of the 
systemic risk in the mentioned area and the main proposals for the financial stability 
reconstruction. To conclude, deep reforms are needed: an adequate financial regulation 
and supervision, the evaluation of the performance over time, new rules for improving 
capital  and  liquidity  and  a  better  communication  between  institutions  in  order  to 
prevent and neutralize possible distress.   
   
1. Introduction 
In the last few years, the financial system has become more complex; the connections 
between its components are the results of financial innovation and deregulation. An 
intense activity, an important amount of transactions and the speed of change reveal the 
consequences  of  the  overexposure  to  risks.  The  loss  of  confidence,  an  increased 
uncertainty,  the  state  of  concern  arising  over  the  financial  system  produce  serious 
effects in the real economy. According to European Central Bank (2010), the systemic 
risk is defined in terms of financial stability- the capacity of reducing and eliminating 
shocks, imbalances and disruption in order to allocate money to profitable investment 
opportunities. Direct and indirect linkages between financial institutions have conducted to rapid transmission of shocks. More than that, the failure of one institution generated 
negative effects in the financial system. Another definition place the systemic risk as the 
risk of ”widespread failures of financial institutions or freezing up of capital markets 
that  can  substantially  reduce  the  supply  of  such  intermediated  capital  to  the  real 
economy” [1, 4]. 
The current financial crisis shows that systemic episodes can arise both from solvency 
and  liquidity  concerns.  The  systemic  events  appear  as  a  result  of  three  forces:  an 
increase in real estate prices, the fall of interest rates, an accelerated efficiency and 
availability of the refinancing opportunities. One of the main sources of instability is 
provided by the risk management policy.  
The  reconstruction  of  a  solid  financial  system  demands  a  correct  evaluation  of  the 
systemic risk and implies finding healthy solutions for countering the negative effects. 
  
2. The evaluation methods of the systemic risk in European Union 
The  large  dimension  of  the  systemic  risk  makes  it  imperative  to  find  a  method  of 
evaluation. Even though there have been many attempts to choose just one measure to 
monitor the risk at European level, none of them proved to be reliable. So, there are at 
least three approaches that can be used to detect systemic risk. 
First approach is taking into consideration a range of measures that can be used to 
discern when  events become systemic, named  financial soundness indicators  (FSIs). 
These indicators are used to monitor the soundness of the financial system and to assess 
systemic risk.  FSIs aggregate micro-prudential indicators are used by supervisors to 
assess soundness of a financial institution. This way they can detect risk to the financial 
system as a whole that might be missed by micro-prudential indicators.  
TAB.1.Macroprudential Indicators of Financial System Soundness 
Aggregated micro prudential indicators  Macroeconomic indicators 
I. Capital adequacy   Economic growth 
II. Asset quality  Balance of payments 
II.1. Lending institution  Inflation  
Borrowing entity  Interest and exchange rate 
Management soundness  Lending and asset price booms 
Earning and profitability  Contagion effects Liquidity  Other factors 
Sensitivity to market risk   
Market-based indicators   
Source:  Evans,  O.,  Leone,  A.,  Gill,  M.,  Hilbers,  P.  –  Macro-prudential 
Indicators of Financial System Soundness, IMF Occasional Papers, Washington DC, 
2000, p. 9 
 
The second approach refers to the inter linkages between financial institutions, both 
domestically and internationally. To indentify the linkages between financial firms there 
can be used four directions [5, 2]:  
- the network approach, which tracks the transmission of financial stress across the 
banking system via linkages in the interbank market;  
- the co-risk model, which uses market data on credit default swaps to assess how the 
default risk of an institution is affected by the default risk of another institution; 
- the distress dependence matrix, which allows analysts to study a group of financial 
institutions and to assess the probability of distress for a pair of institutions, taking into 
account a set of other institutions;  
- the default intensity model, which captures the likelihood of default of a large fraction 
of financial institutions through linkages. 
The final approach takes into consideration data from individual financial institutions in 
order to identify what entities are most likely to experience pressures. A recent study 
conducted by IMF shows that while information from individual financial institutions 
can  help  guard  against  systemic  risk,  not  all  such  information  is  useful.  Also,  data 
collection problems, both in terms of the number of institutions covered and in terms of 
the  timeliness  of  the  data,  are  likely  to  be  important.  The  number  of  systemically 
important  institutions  is  far  smaller  than  the  total  number  of  institutions,  and  data 
availability is less likely to be a problem in the case of large institutions. 
 
3. The main directions for limiting systemic risk in the European Union  
European Union states are characterized by diversity of the architecture and structure of 
financial  systems.  These  circumstances  make  more  difficult  finding  solution  against 
systemic risk, because each country has different approaches regarding oversight and 
regulation of its own financial system. The crisis highlighted the new needs of European Union on supervision of financial 
services. The European Parliament, the most important legislative institution of EU sets 
three principles regarding European financial system: 
- a closer regulation and supervision of alternative investment funds (hedge and equity 
funds); 
- supplementary capital requirements for European banks and a new approach about the 
bonuses that these financial institutions pay out; 
- the supervision of the financial sector – at micro and macro level [3,1]. 
One  of  the  proposed  directives  has  the  main  objective  to  ensure  that  all  alternative 
investment funds will be over sighted and regulated without exemptions. Every fund 
will have an European passport and the possibility of developing financial activities in 
EU. Non-EU funds will be authorized by Member States. Also, the managers of such 
funds  should  inform  the  national  supervisors  of  the  leverage  limit.  Excessive 
compensation of this managers encouraged excessive risk taking. The G20 Pittsburgh 
Summit set principles regarding financial system stability, including a compensation 
based on a long-term value creation. Financial  activities based on derivates become 
extremely  important  today  because  of  their  potential  risk  in  triggering  systemic 
problems. The European financial institutions must work with derivates in certain limits 
of risk-taking. Derivates should retrieve their most important role: reducing a specific 
risk and correcting an anomaly from a financial market. 
In order to ensure the stability of banking system, a vital component of the system, the 
European  Parliament  sets  Capital  Requirements  Directives  III  [4,1].  Through  this 
directive, the European Commission wants to revise EU rules on capital requirements: 
impose  higher  capital  requirements  for  re-securitizations,  limiting  securitization 
exposures  and  restrictiveness  about  risk-taking.  Regarding  executives  bonuses,  the 
directive set maximum cash bonuses of 30%, at least 40% differed for at least three to 
five years, at least 50% will be remunerated in shares and the discretionary pension 
benefits should also be in shares. 
These new directions for European financial institutions should reduce the systemic risk 
and make them more powerful facing the crisis. We consider that expanding stress-tests 
on a large base of financial institutions may discover weakness in system. Also, the role of central banks should be extended over the procedures of commercial banks regarding 
customer  creditworthiness.  Even  the  negative  effect  of  re-securitizations  may  be 
reduced is the basement is solid with clients who can return their credits. 
Monitoring and assessing the potential risks and threats during the crisis were weak and 
incapable to diminish the negative effects manifested in European financial system. This 
is  the  reason  for  creating  the  European  Systemic  Risk  Board,  a  new  authority  with 
responsibilities in detecting irregularities manifested in the countries’ financial systems.  
European Systemic Risk Board will have to issue warnings regarding all the potential 
risks  and  make  recommendations  to  a  country  or  group  of  countries  for  the  good 
functioning of the whole financial system. A potential warning may be made public, 
depending of effects that can appear in case of publicity.   
The new authority will include all central banks governors from the 27 Member States, 
as  well  as  the  countries  which  haven’t  adopted  the  euro  yet.  Assuring  a  global 
supervision  implies  the  presence  of  other  authorities  like  European  Supervisory 
Authorities and national supervisors.   
The existing European supervisory committees will be replaced by a European Banking 
Authority (EBA), European Insurance and Occupational Pensions Authority (EIOPA) 
and a European Securities and Markets Authority (ESMA). They will be a part of a 
network of financial supervisors and will aim a closer supervision of European financial 
system components. The future of supervision in European Union includes cooperation 
between these three institutions, ESRB and the national supervisory authorities.  
The  main  advantage  of  European  Systemic  Risk  Board  should  be  the  multinational 
power in regulating and supervising different institutions from all the financial system. 
Theoretical issues may look encouraging, but the differences between financial system 
architecture  may  be  a  problem  in  implementing  directions  of  action  in  European 
countries. There are many arguments regarding the existence of such institution. An 
appropriate  regulation  and  setting  clear  responsibilities  for  each  supervisor  in  every 
country and for each segment of financial system is a necessary measure which can 
guarantee the success. 
 
4. Conclusion 
The recent financial crisis highlighted once again the importance of risk management  
policies.  The  systemic  events  appear  as  a  result  of  individual  actions  of  financial institutions even though they are highly interconnected. Taking into consideration the 
fact that financial stability is defined as the absence of the systemic risk, it is very 
important to identify the possible sources of it. Policy makers tried to apply different 
measuring methods and concluded that there are at least three approaches: financial 
soundness  indicators,  the  linkages  between  financial  institutions  and  the  individual 
evaluation of firms. Designing an appropriate framework for the systemic risk must be 
followed by efficient proposals and action in order to improve financial stability. Risk 
management should focus on regulation and the quality of supervision. New directives 
have  the  role  to  ensure  an  optimal  level  of  capital,  liquidity  and  solvency.  Macro-
financial  surveillance  and  macro-prudential  supervision  are  vital  and  that  makes 
credible  the  need  for  a  multinational  power  -  European  Systemic  Risk  Board  -  an 
institution capable to assure a global supervision. 
 
Aknowledgements 
 
This work was supported by the the European Social Fund in Romania, under the 
responsibility of the Managing Authority for the Sectoral Operational Programme 
for  Human  Resources  Development  2007-2013  [grant  POSDRU/CPP  107/DMI 
1.5/S/78342]. 
 
References 
[1]  EIJFFINGER,  S.C.W.,  “Defining  and  Measuring  Systemic  Risk”,  European 
Parliament, Brussels, 2009, p. 4 
[2]   EVANS, O., LEONE, A., GILL, M., HILBERS, P.,” Macro prudential Indicators 
of Financial System Soundness”, IMF Occasional Papers, Washington DC, 2000, p. 9 
[3]  ***EUROPEAN  PARLIAMENT,  “Economic  reform  and  stability  for  a  new 
economy: The European Parliament's work”, 2010, p.1 
[4]  ***FRESHFIELD  BRUCKHAUS  DERINGER,  “The  Capital  Requirements 
Directive and Bankers’ Bonuses: Some Questions and Answers”, 2010, p.1 
[5]  ***INTERNATIONAL  MONETARY  FUND,  “Assessing  the  Systemic 
Implications  of  Financial  Linkages”,  Global  Financial  Stability  Report,  Washington 
DC, 2009, p. 2, ISBN: 978-1-58906-809-4 

Evaluating and managing systemic risk in the European Union

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