What is systemic risk?
What is systemic risk and how does it work? Looking for a simple systemic risk definition? We’ve got you covered.
What is systemic risk?
The systemic risk definition is as follows: systemic risk is the risk that the failure of a single company or cluster of companies can bring down the entire industry or lead to a market crash. Usually, markets with interconnected and interdependent institutions are most sensitive to systemic risk.
For example, in a well-established financial sector, a failure of one entity or a small group of entities could have a cascading effect that bankrupts or ruins the entire system, resulting in a severe economic downturn. Companies, whose collapse could have an impact of this scale, are referred to as "systemically important" companies. Banks and other institutions are prominent among them.
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What you need to know about systemic risk...
Systemic risk means the risk that an event at company level could result in the collapse of an entire industry, financial system or overall economy. In fact, it was a major cause of the 2008 financial crisis, resulting in the great recession in the US, which brought to the fore the problem of companies that had grown “too big to fail.”
These are the companies that are so large that their crash could result in national or even international financial catastrophe. A company highly interconnected with others is also considered to be a source of systemic risk.
The collapse of Lehman Brothers in 2008 is one of the most recent examples of systemic risk. As Lehman Brothers was a rather large company, deeply ingrained in the economy, its failure resulted in a domino effect that generated a major risk to the global financial system. This event sent shockwaves throughout the entire industry, requiring government intervention.
Controlling systemic risk is a major concern for regulators, particularly given that consolidation in the banking system has led to the creation of very large financial units. Following the global financial crisis, regulators began to focus on making the banking system less vulnerable to economic shocks.
As of today, national governments have taken a range of steps to intervene in the economy in the hope of preventing such events, reducing or minimising the ripple effect from a company-level incident through targeted regulations and actions. They have developed sensible macroeconomic and microeconomic policies, with increased emphasis on prudential regulation, putting in place safeguards for the stability of the financial system.
Note that systemic risk should not be confused with systematic risk, which describes the danger that the overall market, not just a particular company or industry, may tumble.