Systemic Risk

Definition

Systemic risk refers to the possibility that an event at the company level could trigger severe instability or collapse an entire industry or economy. It is the risk of a major failure of a financial system, which can lead to negative business cycle correlations. Such risk is typically a cascading effect that affects a broad scope of an economy.

Phonetic

The phonetics of the keyword “Systemic Risk” is: siː-stɛ-mɪk rɪsk.

Key Takeaways

<ol> <li>Systemic Risk is the possibility that an event at the company level could trigger severe instability or collapse an entire industry or economy. It refers to the risks imposed by interlinkages and interdependencies in a system or market, where the failure of a single entity or cluster of entities can cause a cascading failure, which could potentially bankrupt or bring down the entire system or market.</li> <li>Systemic risk can be caused by a number of events, including a widespread panic amongst financial institutions, a sudden collapse of a large financial institution, or a sudden loss of confidence in a significant portion of the financial system. When systemic risk is revealed to the market, financial institutions may not want to lend to each other, leading to a liquidity crisis.</li> <li>Managing systemic risk involves monitoring the financial system for vulnerabilities, improving transparency, promoting sound risk management practices, and maintaining effective regulatory standards. Central banks and international financial institutions play a crucial role in managing systemic risks to prevent the collapse of financial markets and economies.</li></ol>

Importance

Systemic risk is crucial in business and finance as it refers to the possibility of a systemic event, such as a financial crisis, that can severely disrupt or even collapse the entire financial system, rather than just individual entities or sectors. This risk arises due to strong interdependencies between institutions such as banks, insurance companies, and investment firms. It’s a key aspect to consider in risk management because its occurrence can lead to a chain reaction that can potentially bring down whole economies, making its potential impact significantly larger and more devastating than other types of financial risks. Understanding and managing systemic risk helps in stabilizing financial systems and preventing economic downturns.

Explanation

Systemic Risk serves as a key concept within the financial sector, as it refers to the risk that the failure of a bank, financial institution or an entire financial system could trigger a broad-based economic crisis. The identification and management of systemic risk are crucial for the stability of the financial markets and overall economy. This is because systemic risks can lead to cascading failures throughout the financial system, causing widespread financial instability or even a complete economic meltdown. The global financial crisis of 2008 is a prime example of how uncontrolled systemic risk can lead to catastrophic economic consequences.The purpose of examining systemic risk is to identify vulnerabilities within the financial system that may be susceptible to shocks, and to implement safeguards against them. Regulatory authorities, such as central banks, monitor systemic risk by analyzing market data, conducting stress tests on financial institutions, and tracking key indicators of economic health such as GDP growth, inflation rates, and unemployment rates. By addressing systemic risk, regulators not only ensure the smooth functioning of the financial markets on a day-to-day basis, but also protect the economy from potential financial crises in the future. Thus, systemic risk serves as a barometer of financial stability and an essential tool for risk management in the global economic landscape.

Examples

1. The 2008 Financial Crisis: Systemic risk was a significant factor in the global financial crisis that started in 2008. The collapse of the investment bank, Lehman Brothers, due to its exposure to subprime mortgage-backed securities led to fear and uncertainty throughout the entire banking system. This caused a global credit crunch, where banks became reluctant to lend to each other doubting the solvency of other banks, which amplified the overall systemic risk.2. The Dotcom Bubble in the early 2000s: The rapid growth of internet-based companies in the late 1990s created a speculative bubble in tech stocks. When the bubble burst, the entire tech industry was affected, causing a major recession in the global economy. The collapse of the stock market and the simultaneous failure of several technology companies showed systemic risk, as it had a cascading effect on the entire economy.3. The Covid-19 Pandemic: The global outbreak of the coronavirus has caused a substantial amount of systemic risk. The immediate shutdown of businesses across the globe due to lockdowns and quarantine measures greatly impacted global financial markets and precipitated an economic crisis. This was further exacerbated by the uncertainty of the virus, as it led to significant consumption and investment behavior changes, causing secondary impacts on markets and economies around the world.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Financial Contagion
• Global Financial System
• Market Collapse
• Risk Management
• Too Big to Fail

Sources for More Information

• Investopedia
• Corporate Finance Institute
• Bank for International Settlements
• Federal Reserve Bank of St. Louis