Systemic Risk
A failure of the entire financial system as opposed to the failure of a single component, such as the financial sector.
What is Systemic Risk?
The financial sector is intertwined with the financial system. Therefore, a significant collapse in the financial industry will inevitably lead to cascading problems in the financial system and ultimately lead to an economic downfall.
The term "systemic risk" is used to describe the possibility of a failure of the entire financial system instead of the loss of a single component, such as the financial sector.
It refers to the risk of a failure in the financial sector that results in a loss in the financial system.
But what differentiates the financial sector from the financial system? For starters, the term financial system encompasses the financial industry and other sectors to the extent that they require financial services.
On the other hand, the financial sector is an amalgamation of financial institutions like banks, equity markets, etc., that provide services to other industries when needed.
It is important to note that this risk is not restricted to an economic context. Instead, it can be used in the context of system-related risks in different sectors of the economy.
This risk typically alludes to the possibility of a company or industry-level event triggering instability in the entire economy. This risk played a significant role in the 2008 financial crisis. We will discuss this further in a later section.
The phrase "too big to fail" refers to corporations carrying systemic risks.
These companies are so big that they form a considerable portion of the industry and/or the overall economy. Therefore, any failure within these companies could lead to severe economic consequences.
Companies highly interconnected with other institutions are also a vast systemic risk as several institutions may depend on their services.
Key Takeaways
The following section recapitulates what we have learned throughout this discussion. Mentioned below are our key takeaways:
- The risk connected to the breakdown or collapse of a business, sector, financial institution, or overall economy is known as systemic risk.
- It is inherent in an economy and, thus, cannot be mitigated through diversification.
- The risk, like a virus, can spread from unhealthy financial institutions to healthy ones, causing economic instability or crises.
- It is easy to confuse systemic risk with systematic or idiosyncratic risk. However, systematic risk alludes to the potential for failure that affects the market as a whole rather than just one specific organization.
- Similarly, idiosyncratic risk is the risk that comes with a specific business or sector. It can be reduced through diversification.
- The downfall of the Lehman Brothers during the 2007-08 financial crisis is a prime example of how systemic risk can have dire consequences on the economy if ignored.
- Global governments have put in place several measures to help lessen the blow of this risk.
- The financial market is more exposed to this risk than other parts of the economy because it is heavily integrated. Financial institutions are exposed to one another.
- Hence, the collapse of one financial institution can easily trigger others.
Although this risk is undesirable, it is ever-present in the economy. Hence, investment decisions must be made while keeping it in mind.
Systemic Risk vs. Systematic Risk vs. Idiosyncratic Risk
It is easy to confuse systemic risk for idiosyncratic risk or systematic risk. This section points out the differences between these three distinct risk types to make it easier for you to distinguish between them.
| Systemic Risk | Systematic Risk | Idiosyncratic Risk |
|---|---|---|
| Refers to the possible failure of an entire business, sector, industry, or economy. | Refers to the possibility of failure that impacts the entire market, not just a single entity. | It is the risk that is inherent to a particular company or industry. |
| It cannot be mitigated by diversifying investments. However, hedging or using the recommended asset allocation strategy can help prevent the risk. | It cannot be mitigated by diversifying investments as it impacts all securities. | It can be mitigated by diversifying investments. |
| It is difficult to quantify and foresee it since it is nearly impossible to forecast the magnitude of an institution's or entity's impact or collapse. | Since systematic risk affects the entire economy and occurs on a larger scale, monitoring and quantifying it is relatively simpler. | A stock's idiosyncratic risk can be calculated as its variation above the market's systematic risk. |
| A financial company filing for bankruptcy is an example of this type of risk. |
The global economic recession induced by the coronavirus pandemic is an example of this risk. | A dock workers’ strike is an example of this type of risk in the context of the shipment industry. |
Examples of Systemic Risk
Let us consider the following real-life example of Lehman Brothers to strengthen our understanding of this risk.
Lehman Brothers was a large investment banking company whose size made it a systemic risk to the US economy.
During the 2007-08 financial crisis, the bank expanded into mortgage-backed securities and collateral debt obligations like many other financial firms.
Lehman Brothers made Alt-A loans to borrowers without documentation when the housing bubble was full.
Then, when the housing market finally crashed, the bank was forced to declare bankruptcy, and dozens of employees were left jobless. The bank's collapse left cracks in the financial system and overall economy.
Capital markets were in shambles. Consumers and businesses were denied loans. Only those with exceptional creditworthiness could obtain a loan if they presented little to no risk to the lender.
The bank's downfall represented the excesses of the 2007–08 Financial Crisis. The subprime catastrophe raced through financial markets and caused an estimated $10 trillion lost economic output.
Lehman had 25,000 workers worldwide and was the fourth biggest investment bank in the US at its demise. As a result, the risk was high and cost the US economy severely.
Prevention of Systemic Risk
Regulations may help lessen this risk if they are appropriately created and implemented. The following section goes over some of the rules in place to reduce the impact of such bets.
Regional, governmental, and even international forces might be used to mitigate this risk.
Financial risk managers have access to regulatory tools and legally binding solutions to manage threats inside an economy since such a risk has the potential to entirely or partially collapse an economy.
This allows regulators to look into deposit flows, equity returns, debt-risk premiums, and other exposures.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) established an Office of Financial Research (OFR) in the United States to keep track of trends in the worldwide market that could cause systemic failure.
Dodd-Frank permits the Federal Deposit Insurance Corporation (FDIC) to guarantee the assets and liabilities of failed financial institutions, notwithstanding the law's assertion that federal bailouts are obsolete.
It also requires that the Feds compile a list of systemically important companies for special supervision.
Many international and European organizations are also working to reduce this economic risk.
The G-20 nations have raised Basel III capital requirements for financial institutions to decrease bank leverage.
The European Union has also sought to establish the European Financial Stability Facility (EFSF) to offer member states short-term assistance with their fiscal debts and deficits.
The European Stabilization Mechanism, a €750 billion organization that aids member nations, includes a sizable portion of the EFSF.
Impact of Systemic Risk on the Diversification
As previously discussed, systemic risk cannot be diversified away. It is thus essential to understand why this risk is hard to mitigate and how it may impact an investment portfolio.
For starters, this risk has an immediate impact on all policies simultaneously. There is no single policy that is not impacted by this risk.
We can investigate the effects of its existence on the risk loading of a portfolio of insurance policy premiums using a probabilistic approach. Applying this strategy to the stock market and investment risk is manageable.
It can then be observed that this risk dramatically lessens the advantages of diversification, even with a low probability of occurrence.
Further, financial systems are even more susceptible to this type of risk relative to other areas and parts of the economy. But why is this the case?
The structure of banks' balance sheets reveals that they frequently use the maximum amount of leverage.
The intricate web of exposures across financial institutions poses a severe risk that remaining banks will lose some or all of their investments if one bank fails.
If such a collapse occurs quickly or unexpectedly, there can be losses big enough to put the responding banks in danger or bring them to ruin.
Regulators and risk managers may encounter difficulties when attempting to manage this risk due to the intertemporal structure of financial transactions.
Overall, systemic risk is difficult to escape since it affects the market as a whole. However, the government needs to ensure its financial systems are running smoothly and resilient enough to avoid any failures while also delivering good economic results.
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