Key Definitions in Finance and Macroeconomics

Key Financial and Economic Definitions

Systemic Risk

The possibility that an event originating at the micro or company level could trigger severe instability or collapse an entire industry or economy.

Macroprudential Policies

Policies or actions related to the whole or significant parts of the financial system, aimed at promoting sound practices and limiting risk-taking. (Source: ECB)

Stress Tests

Simulations conducted under a number of problematic scenarios to assess whether an institution (typically a bank) can endure adverse market developments.

Systemically Important Financial Institutions (SIFIs)

Financial institutions (such as banks, insurance companies, etc.) whose failure may cause severe problems in the financial market due to their size and/or interconnectedness to the rest of the system.

Globally Systemically Important Financial Institutions (G-SIFIs)

A subset of SIFIs designated as globally significant.

Too Big To Fail (TBTF)

A situation where an entity (such as a company, financial institution, state, or province) is so large, in economic terms, that allowing it to fail would have catastrophic consequences for the economy. Consequently, the government is compelled to intervene and "rescue" it.

The concept of Too Big To Fail is often cited as a prime example of Time Inconsistency.

Tail Events

Events that are rare (i.e., with low probability, often defined as the value moving more than three standard deviations (SD) from the current point) but have a high impact.

Black Swan Theory

A concept revolving around the idea that rare events are often discarded when making predictions and rationalized when explaining past events. However, if these events have a large impact, they can have long-lasting effects.

Irrational Exuberance

Enthusiasm (often displayed by investors) that is not backed up by underlying reality, but nevertheless drives prices (typically asset prices) upward.

Real Economy

The segment of the economy that deals with the production and sale of actual goods and services, distinct from operations in the financial markets.

Wealth Effect (or Poverty Effect)

The phenomenon where, as the value of assets rises, individuals (and potentially firms) perceive an increase in their wealth and subsequently increase their spending.

Leverage

Debt used to acquire assets. When a company, sector, or economy is described as "highly leveraged," it means it holds large quantities of debt compared to its equity (the value of assets net of their liabilities).

Deleveraging

The reduction of the amount of debt on a balance sheet, usually achieved by selling assets.

At a macro level, this refers to a widespread reduction of debt across the economy, reflected in a decline of debt as a percentage of GDP.

Hard Currency

A globally traded currency that serves as a reliable and stable store of value. Its value remains relatively stable over time, generating little uncertainty.

Interbank Lending

The practice of banks lending funds to each other (usually for short periods of time) to meet legal requirements that mandate holding a certain amount of liquid assets.