Systemic risk

3 key takeaways

• Systemic risk involves the threat of a domino effect where the failure of one or more significant institutions or markets can trigger widespread financial instability.
• It is often exacerbated by interconnectedness and interdependencies within the financial system, including financial institutions, markets, and instruments.
• Understanding systemic risk is crucial for financial regulation, risk management, and the stability of the overall economy.

What is systemic risk?

Systemic risk is the risk of collapse or severe instability in the entire financial system or market, rather than just one individual entity. It arises when the failure of a single institution or a small group of institutions can cause a chain reaction, leading to significant adverse effects on other institutions and the broader economy. Systemic risk is particularly concerning because it can lead to large-scale economic disruptions, loss of confidence in financial markets, and severe economic downturns.

The interconnectedness of financial institutions, markets, and instruments amplifies systemic risk. For example, banks lending to each other, financial institutions holding similar assets, and complex financial products like derivatives can all contribute to systemic vulnerabilities.

How does systemic risk work?

• Interconnectedness: Financial institutions and markets are highly interconnected, meaning the distress or failure of one entity can quickly spread to others. For instance, if a major bank fails, it can lead to losses for other banks that have exposure to it.
• Contagion: The risk of contagion occurs when the financial distress of one institution spreads to others. This can happen through direct financial links, such as interbank lending, or through indirect effects, such as a loss of confidence that leads to bank runs.
• Market disruptions: Systemic risk can lead to disruptions in financial markets, such as severe price volatility, liquidity shortages, and the breakdown of market mechanisms. This can impair the functioning of financial markets and the broader economy.
• Economic impact: When systemic risk materializes, it can lead to significant economic consequences, including recession, high unemployment, and widespread financial losses. The impact can be long-lasting and challenging to mitigate.

Examples of systemic risk

• Global financial crisis (2007-2008): The collapse of Lehman Brothers and the ensuing financial crisis highlighted systemic risk. The interconnectedness of financial institutions and the widespread exposure to toxic mortgage-backed securities led to a severe global economic downturn.
• Eurozone sovereign debt crisis (2010-2012): The financial instability in several Eurozone countries, particularly Greece, posed systemic risks to the entire Eurozone due to the interconnectedness of European banks and the common currency.
• Long-Term Capital Management (1998): The near-collapse of the hedge fund Long-Term Capital Management (LTCM) posed a systemic risk due to its extensive leverage and the large positions it held in global financial markets. The Federal Reserve intervened to facilitate a bailout to prevent a broader financial crisis.

Understanding systemic risk is essential for financial regulation and risk management. Regulators and policymakers aim to identify and mitigate systemic risks through measures such as capital requirements, stress testing, and the oversight of systemically important financial institutions (SIFIs). For further exploration, consider studying the tools and strategies used to manage systemic risk, the role of central banks in maintaining financial stability, and the impact of regulatory reforms implemented after major financial crises.

It should be distinguished from: systematic risk.