What is the difference between systematic and unsystematic risks? Is it true that regulators are more interested in systematic risks while individual banks give equal importance to both? Please share your views.
Market risk (systematic risk)
The risk that affects all players in the marketplace is called ‘market risk’ or ‘systematic risk’. Changes in economic fundamentals (interest rates, exchange rates, inflation, consumer demand, the price of key commodities such as oil, etc.). Market risk is measured by the beta coefficient. The market (JSE) has a beta of 1, the market’s riskiness relative to itself. Shares/portfolios with a beta greater than 1 (say 1,2) face a bigger risk than the market. Shares/portfolios with a b ta l ss than 1 (say 0,8) face a smaller risk than the market.
According to Joseph (2013), Systematic risks are defined as external influences that affect all firms and households in a country or economic system and are considered uncontrolled risks. For example, if the economy is experiencing a severe economic crisis or recession, bankruptcies will grow, resulting in credit losses, stock markets will fall due to fewer corporate profits, and unemployment will rise, among other repercussions. As a result, systemic hazards have an influence on everyone in the playground (viz. economy). Similarly, political risks such as a military coup, a newly elected government terminating particular policies and programs, wars, terrorism, international isolation, and a variety of other political risks can have a significant impact on the credit asset’s quality and result in losses.
Firm-specific risk (unsystematic risk)
The risk associated with the basic functions of the organization (information technology, production processes, product-markets, innovation, financing, leadership, human skills, etc.). This is an operational/business risk. It is often assumed that management can eliminate this risk by diversification or simply managing better. According to Joseph (2013), unsystematic risk is a controllable risk, through the management of the financial risk of the organization, which is the management of the leverage or the gearing of the organization. According to Joseph (2013:255) diversifiable risk, also known as non-systematic risk or particular risk, is a type of risk that can be reduced by diversifying one’s credit portfolio. All significant firms’ specific risks (industrial, internal, and financial risks) can theoretically be diversified.
Unsystematic risks do not affect the entire economy or all business enterprises/households. Such risks are largely industry-specific and/or firm-specific. By giving credit to a variety of clients, a company can diversify its risks. An intelligent credit portfolio manager or credit team will diversify away from the risks in such a manner that only systematic risks remain a matter of concern. One important rule of diversification is to combine assets that are negatively correlated or less correlated or with zero correlation.
Because diversification eliminates non-systematic risk, it is acceptable to argue that the only sort of risk that should be rewarded in credit risk is systematic risk. This is the direction in which every portfolio manager wishes to steer his or her portfolio so that he or she may concentrate on and design methods to address changes in systematic risk variables.
individual banks give equal importance to both risks, mainly because each individual firm or bank will need to consider their financial risk which is the risk it diversifies. Not managing this risk well, will lead to the collapse of the bank. On the other, systematic will have to be considered because the changes in the market will also affect the profitability or loss-making of the bank.
References
Joseph, J (2013). Advanced credit risk analysis and management. West Sussex, UK: Wiley.