Definition
Systemic risk is the possibility that an event at the economic, industry, or financial system level could trigger severe instability or collapse of an entire market or financial system. This type of risk affects many entities simultaneously and cannot be mitigated through diversification. Systemic risk can arise from factors such as economic recessions, natural disasters, significant geopolitical events, or the failure of major financial institutions.
Examples
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2008 Financial Crisis: The collapse of Lehman Brothers in 2008 is a prominent example of systemic risk. The failure of this major financial institution led to a domino effect, causing widespread panic and massive financial instability across the world. The incident highlighted the interconnectedness of financial institutions and markets, demonstrating how the failure of one entity could endanger the entire financial system.
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COVID-19 Pandemic: The global outbreak of COVID-19 caused extensive market uncertainties, affecting economies around the globe. Stock markets plummeted, supply chains were disrupted, and industries such as travel and hospitality saw substantial financial strain. This widespread disruption is considered systemic risk as it could not be mitigated by individual companies or by diversification within investment portfolios.
FAQs
Q1: How is systemic risk different from idiosyncratic risk? A1: Systemic risk affects an entire market or financial system and cannot be eliminated by diversification. In contrast, idiosyncratic risk is the risk inherent to a specific company or industry, which can be mitigated through diversification.
Q2: Can systemic risk be insured against? A2: Generally, systemic risk cannot be insured against because it impacts wide sectors and systems. Insurance companies themselves are part of the financial system that systemic risks affect.
Q3: What role do central banks play in managing systemic risk? A3: Central banks often play a critical role in managing systemic risk by providing liquidity support, ensuring stable financial conditions, and sometimes acting as a lender of last resort to prevent financial systemic collapse.
Q4: Is systemic risk predictable? A4: While systemic risks are difficult to predict specifically, certain risk management tools and analyses, such as stress testing, can help identify potential systemic vulnerabilities within the financial system.
Related Terms
- Market Risk: The risk of losses in positions arising from movements in market prices.
- Credit Risk: The risk that a borrower will default on any type of debt by failing to make required payments.
- Liquidity Risk: The risk that an entity will not be able to meet its short-term financial obligations due to an inability to convert assets to cash without incurring a loss.
- Operational Risk: The risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events.
Online Resources
- Investopedia’s Guide to Systemic Risk
- Federal Reserve Bank - Financial Stability
- International Monetary Fund (IMF) — Systemic Risk Report
References
- Financial Stability Oversight Council (FSOC) Annual Report.
- Basel Committee on Banking Supervision (BCBS) publications.
- Various industry whitepapers on systemic risk analysis and management.
Suggested Books for Further Studies
- “Systemic Risk: History, Measurement, and Implications for the Future” by Daniel González-Castillo.
- “Too Big to Fail” by Andrew Ross Sorkin.
- “The Alchemy of Finance” by George Soros.
- “Manias, Panics, and Crashes: A History of Financial Crises” by Charles P. Kindleberger and Robert Z. Aliber.
