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Systemic Risk: Definition, Causes, and Preventions

Systemic Risk: Definition, Causes, and Preventions

Systemic risk refers to the risk that threatens the stability of the entire financial system and economy. Systemic risk arises from interlinkages and interdependencies between institutions, markets, and infrastructure within the financial system. Systemic risks have devastating ripple effects that spread through the whole economy.

The interconnectedness between large financial institutions is one of the main causes of systemic risk. Big banks and financial institutions are closely interconnected through investments, loans, and trading relationships, and the failure of one institution leads to the failure of others. This creates a domino effect that threatens the whole system.

Excessive risk-taking also causes systemic risk. Many institutions engage in excessive risk-taking behavior, especially with high leverage, which amplifies the impact of negative shocks and endangers the financial system. The financial crisis of 2008 was exacerbated by excessive risk-taking in the housing and mortgage markets.

Lack of transparency also causes systemic risk. The connections and exposures between institutions are opaque and difficult to monitor, and it is hard for regulators and market participants to recognize systemic vulnerabilities early enough. More transparency is needed to identify and mitigate systemic risks.

To help prevent systemic crises, policymakers and regulators have introduced reforms to strengthen the financial system, increase transparency, curb risk-taking incentives, and develop macroprudential oversight and tools. By identifying and addressing systemic risks early, the probability and impact of future financial crises are reduced.

What exactly is a Systemic Risk?

Systemic risk is the risk of a breakdown in the financial system that could lead to a severe economic crisis. It can arise from interconnectedness and interdependence between financial institutions, markets, and infrastructure. One part of the system failing have repercussions that spread widely and endanger the system as a whole.

Systemic risk has three key characteristics. It threatens the core functions and operations of the financial system. This includes mechanisms for borrowing, lending, payment, settlement, and asset pricing. Shocks are amplified and spread through the system. Due to interconnectivity, a shock that initially impacts only a few institutions or markets spread rapidly and damages the entire system. This contagion and spillover effect is at the heart of systemic risk. It leads to substantial costs and economic damage. Systemic financial crises can lead to large economic costs in terms of lost output, higher unemployment, fiscal burdens, etc. These consequences highlight why systemic risk is so dangerous.

The global financial crisis of 2008 is an example of a systemic crisis. It was triggered by a housing crisis in the U.S called Subprime mortgage crisi,  but due to the complexity and interconnectedness of the system, its impact spread globally through contagion between markets, banks, consumers and economies. Many systemically important banks failed, credit markets froze up, asset prices declined sharply, and the crisis imposed huge costs on taxpayers and society.

Systemic risk differs from systematic risk, which refers to the risk that affects all companies in the market due to macroeconomic factors. Systemic risk specifically originates within the financial system itself, often due to mismanagement or fragility, and then spreads to the wider economy. It highlights the importance of taking a system-wide view of risk instead of only looking at risks affecting individual components. 

financial crisis of 2008 is an example of a systemic crisis
How the Recession of 2008-09 Happened

Systemic risk differs from systematic risk, which refers to the risk that affects all companies in the market due to macroeconomic factors. Systemic risk specifically originates within the financial system itself, often due to mismanagement or fragility, and then spreads to the wider economy. It highlights the importance of taking a system-wide view of risk instead of only looking at risks affecting individual components. 

How does Systemic Risk function?

Systemic risk spreads through interconnections between institutions, markets, and infrastructure in the financial system. First, contagion refers to how the failure of one institution spread to other connected institutions through contractual obligations or exposures. For example, Bank A fails and defaults on its obligations to Bank B means it threaten Bank B’s solvency. This contagion continues spreading systemwide.

How does Systemic Risk function?
How do Systemic Risk works?

Second, flight to quality refers to how risks in one market can lead investors to flee to safer assets in other markets. Mortgage market issues may lead investors to withdraw funds from equities, bonds, commodities and other assets. This disrupts multiple markets and creates spillovers.   Third, common exposures refer to how issues with assets that many institutions invested in or lent to can pose systemic threats. For example, exposure to risky mortgage-backed securities contributed to the 2008 financial crisis.

Finally, systemic risk spreads through critical financial infrastructure like payment systems. If these mechanisms fail, it disrupts the entire system.

Understanding systemic risk is crucial because its impacts are damaging. Financial crises often lead to lost GDP, higher unemployment, and taxpayer bailouts. Systemic risk also threatens borrowing, lending, saving, payment, clearing, settlement, and asset pricing mechanisms.  

Some risk is inherent, but systemic risk is undesirable. Regulators curb systemic risk through policies strengthening the financial system, limiting contagion, and providing emergency backstops. Mitigating systemic risk is vital for financial stability and growth.

What are the causes of Systemic Risk?

Systemic risk refers to the potential for the collapse or failure of an entire financial system or market due to the failure of a single component or interconnected entities. This lead to widespread economic consequences and necessitates government intervention or bailout. Below are six common causes of systemic risk.

1. Inconsistencies in Foreign Exchange in the Financial System

Inconsistencies in foreign exchange refer to fluctuations in the value of different currencies, which lead to imbalances in the financial system and impact international trade, investments, and capital flows. Exchange rate fluctuations are caused by factors, such as changes in interest rates, inflation, and political events.

They lead to sudden capital movements and mismatches in asset and liability values Currencies fluctuate in value, and financial institutions face difficulties in managing their currency exposures and maintaining their asset and liability valuations. A large number of financial institutions exposed to these fluctuations lead to a domino effect, causing widespread defaults and failures in the financial system.

2. Banking Panics

Banking panics occur when a large number of depositors lose confidence in their bank’s ability to return their funds and rush to withdraw their deposits, leading to a liquidity crisis. Banking panics are triggered by factors such as rumors of insolvency, financial sandals, or economic downturns. Banks are often forced to sell assets at a loss to meet withdrawal demands, causing a decline in asset prices and further erosion of confidence in the financial system.

A widespread banking panic led to the collapse of multiple banks, which then spill over into other sectors of the economy and cause a systemic crisis.

3. Asset Price Declines

Asset price declines refer to a significant drop in the value of various types of assets, such as stocks, bonds, or real estate. Asset prices decline because of factors such as changes in market sentiment, economic downturns, or regulatory changes.

As asset prices drop, the value of investments held by financial institutions may decline sharply, leading to losses and potential insolvency. Widespread declines in asset prices lead to a chain reaction of failures among interconnected financial institutions, resulting in a systemic crisis.

4. Contagion

Contagion refers to the spread of financial instability from one institution or market to another, often due to a lack of confidence or perceived risk. Contagion results from the interconnected nature of financial markets and institutions, as well as the herding behavior of investors.

Contagion causes a shock in one part of the financial system and quickly spread to other parts, leading to a broader crisis. Contagion exacerbates existing vulnerabilities in the financial system and increases the likelihood of a systemic crisis.

5. Uncharted Waters

Uncharted waters refer to situations in which financial markets or institutions face unprecedented challenges, often due to new financial products, technologies, or regulatory environments. Uncharted waters create uncertainty and increase the potential for financial instability.

Financial institutions will struggle to adapt to new challenges, leading to mismanagement of risks and potential failures. As multiple institutions navigate uncharted waters, the potential for systemic risk increases due to the uncertainty and interconnectedness of the financial system.

6. Financial Architecture

Financial architecture refers to the structure and design of financial markets and institutions, including regulations, market practices, and infrastructures. The design of the financial architecture impacts the stability and resilience of the financial system. Flaws in the financial architecture lead to inefficiencies, increased risk-taking, and vulnerabilities in the financial system. A poorly designed financial architecture increases the likelihood of systemic risk by allowing vulnerabilities to accumulate and spread throughout the financial system.

Systemic risk poses a significant threat to the stability and resilience of financial systems, with the potential to cause widespread economic disruption. Factors contribute to systemic risk, including inconsistencies in foreign exchange, banking panics, asset price declines, contagion, uncharted waters, and flaws in financial architecture.

Understanding these causes is crucial for regulators, policymakers, and financial institutions to develop strategies to mitigate systemic risk and enhance the overall stability of the financial system. By addressing these underlying issues, it is possible to build a more robust and resilient financial landscape that can withstand shocks and prevent systemic crises.

What are the preventions to avoid Systemic Risk?

What are the preventions to avoid Systemic Risk?

Preventive measures are implemented to avoid systemic risk and enhance the stability of the financial system. These measures aim to address the underlying causes of systemic risk and strengthen the resilience of financial institutions and markets. Below are six common prevention strategies.

1. Resolution System

A resolution system is a set of tools and mechanisms used by regulators and authorities to manage the orderly resolution of failing financial institutions, thereby minimizing the impact of their failure on the broader financial system.

Effective resolution systems include measures such as bail-in powers, bridge institutions, and asset separation. By providing a framework for the orderly resolution of failing institutions, a resolution system prevents the spread of financial instability and contagion, reducing the likelihood of systemic crises.

2. Improved Capital and Liquidity

Improved capital and liquidity refer to higher capital and liquidity requirements for financial institutions, ensuring that they hold sufficient resources to absorb losses and meet their financial obligations. Capital and liquidity requirements are implemented through regulatory measures such as Basel III and stress testing.

By ensuring that financial institutions maintain adequate capital and liquidity buffers, these measures enhance their resilience to financial shocks and reduce the likelihood of widespread failures and systemic risk.

3. Increased Market Robustness

Increased market robustness refers to measures aimed at enhancing the stability and functioning of financial markets, such as improved market infrastructure, transparency, and risk management practices. Examples of increased market robustness include the implementation of central clearing for standardized derivatives and the improvement of trade reporting requirements. By promoting more stable and transparent financial markets, these measures reduce the potential for contagion and financial instability, thereby lowering systemic risk.

4. The Financial Industry’s Structure

The financial industry’s structure refers to the organization and interconnectedness of financial institutions and markets, which is influenced by regulatory measures and industry practices. Measures to address the financial industry’s structure include implementing rules to limit the concentration of risks, addressing “too big to fail” issues, and promoting competition and diversity within the financial sector.

By enhancing the structure of the financial industry, these measures reduce concentration risks, limit the potential for contagion, and increase the overall resilience of the financial system.

5. Supervision

Supervision refers to the oversight and regulation of financial institutions by regulatory authorities, aimed at ensuring the safety, soundness, and compliance of these institutions. Effective supervision involves monitoring financial institutions’ risk management practices, capital and liquidity positions, and overall financial health.

Through robust supervision, regulators identify potential vulnerabilities in financial institutions and take corrective actions before they lead to systemic issues, thereby reducing the likelihood of systemic risk.

6. Taxation

Taxation refers to the use of fiscal policy tools, such as taxes and subsidies, to influence the behavior of financial institutions and markets. Taxation is used to address systemic risk by discouraging excessive risk-taking, encouraging long-term investment, and ensuring the financial sector contributes to the costs of financial stability. By using taxation to influence the behavior of financial institutions and markets, policymakers promote financial stability and reduce the likelihood of systemic crises.

The prevention of systemic risk is crucial for maintaining the stability and resilience of the financial system and the above systems help do the same.

What are the benefits of Systemic Risk?

Systemic risk is typically associated with negative consequences such as financial crises and economic recession, but it should also be recognized that systemic risk may bring certain indirect advantages as well. Below are six benefits of systemic risk.

1. Increased Awareness and Regulatory Reforms

Systemic risk heighten awareness of potential vulnerabilities within the financial system, motivating policymakers, financial institutions, and market participants alike to introduce regulatory reforms and enhance risk management practices that strengthen overall financial stability.

2. Market Discipline

Systemic risk prompts market discipline among financial institutions and market participants. Such discipline promotes safe risk-taking behavior, transparency, and proper governance to enhance the stability and resilience of the financial system as a whole.

3. Encourage Innovation

Systemic risk act as a catalyst for innovation among financial institutions and market participants alike, as they attempt to devise products, services, or strategies to manage or mitigate it. Such innovations may create more efficient and dynamic financial systems thereby contributing to long-term economic growth.

4. Stress Testing and Scenario Analysis

In light of systemic risk, regulators and financial institutions are encouraged to conduct regular stress tests and scenario analyses in order to identify vulnerabilities and assess resilience to adverse events, which in turn allows them to create more efficient risk management practices and improved capital planning – ultimately strengthening the stability of their respective financial systems.

5. Shared Responsibility

Systemic risk creates a sense of collective responsibility among financial institutions, market participants, and regulators. Given its interdependent nature, all stakeholders may work together toward mitigating systemic risk through greater cooperation and coordination in pursuit of financial stability.

Systemic risk has positive consequences beyond its negatives; such as driving regulatory reforms, market discipline improvements and innovation initiatives; improved risk management practices, and cooperation among financial stakeholders – but to take full advantage of them while taking necessary precautions against it in order to preserve financial stability and long-term economic growth.

To find balance in this regard it’s key to find an equilibrium between exploiting its indirect benefits while taking adequate steps to avoid or mitigate systemic risk in order to ensure financial stability and growth over time.

What are the downsides of Systemic Risk?

Systemic risks have serious negative repercussions for an economy, financial institutions, and individuals. Below are six main drawbacks of systemic risk.

 1. Financial Crises

A key downside of systemic risk is the possibility of financial crises, which trigger severe economic downturns like recessions or depressions. Financial crises result in massive losses for financial institutions, businesses, and individuals and take years for them to fully recover from. Systemic risk results in contagion, whereby distress or failure at one financial institution or market spreads rapidly to others, exacerbating financial crises further while further destabilizing the entire financial system.

2. Loss of Confidence

Systemic risk erode investor and consumer trust in the financial system, prompting investors and consumers alike to withdraw funds, cut spending and defer investments – ultimately slowing economic activity growth while possibly even leading to recessions.

3. “Too Big to Fail” Is an Issue

Systemic risk creates the “too big to fail” dilemma, in which certain financial institutions become so large and interconnected that their collapse would threaten the overall financial system. This creates a moral hazard as these institutions engage in more risky activities knowing they will likely receive government support in case of crisis.

 4. Government Bailouts and Fiscal Burden

Systemic risk result in government bailouts of struggling financial institutions to prevent further system collapse, placing an undue financial strain on both governments and taxpayers, potentially leading to higher taxes, reduced public spending, and an increase in public debt.

5, Unemployment and Social Costs

Systemic risk leads to higher unemployment rates as businesses struggle to remain operational during financial crises and need to lay off employees or close completely, creating substantial social costs such as increased poverty, reduced quality of life, and an increase in crime.

6.. Wealth Inequality

Systemic risk exacerbates wealth inequality as asset prices often plummet during crises, negatively affecting lower-income individuals disproportionately and benefiting wealthier people more during recovery efforts – further widening wealth gaps.

Systemic risks have severe and far-reaching repercussions for financial institutions, businesses, governments, and individuals. Thus, mitigating systemic risk is integral to maintaining financial stability and driving long-term economic development.

What are the examples of Systemic Risk?

The most notorious example of systemic risk is The Global Financial Crisis of 2008. The crisis was triggered by the bursting of the US housing bubble and the subprime mortgage crisis. It led to the failure of major financial institutions, the collapse of stock markets around the world, and a global economic downturn. This was a classic case of systemic risk in the financial system spreading to the real economy.

The European Sovereign Debt Crisis is also an example. Excessive government debt levels in several European countries like Greece, Spain, Italy etc. threatened the stability of the European banking system and economy. There were fears of sovereign defaults, bank failures, and a wider economic crisis. This is an example of systemic risk spreading from one part of the economy (sovereigns) to the broader financial system. Below are three more similar examples.

The Asian Financial Crisis of 1997

The crisis started in Thailand with the collapse of the Thai baht but spread to other Asian economies like Malaysia, Indonesia, South Korea, and Hong Kong. It led to slumping currencies, bankruptcies, falling asset prices, and negative economic growth across Asia. This shows how a crisis in one economy can spread rapidly to others due to economic linkages and dependencies.

The Collapse of Long-Term Capital Management (LTCM) in 1998

LTCM was a large US hedge fund that collapsed due to excessive leverage and risk-taking. The Federal Reserve had to orchestrate a bailout to prevent systemic risk to the wider US financial system as LTCM’s collapse could have had a ripple effect. This illustrates how troubles at one institution can endanger the entire system.  

The Flash Crash of 2010

On May 6, 2010, the US stock market experienced a trillion-dollar collapse and recovery all in about 36 minutes. Although the root cause was algorithmic trading and technical glitches, it highlighted the fragility and interconnectedness of modern financial markets. Significant drops in asset prices could damage confidence and impact the real economy – a case of systemic risk from the markets to the broader economic system.

How does Systemic Risk affect the Stock Market?

Systemic risk negatively impacts the stock market. Investors become risk-averse and engage in the mass selling of assets like stocks during systemic risk. This flight to safety leads to a plunge in stock prices across the board. For example, during the 2008 financial crisis, the US S&P 500 index fell by over 50% from peak to trough as systemic risk erupted.

Systemic risk events are accompanied by increased volatility in the stock market. As fear takes over, markets tend to overreact and swing wildly. This makes the stock market very turbulent and unpredictable. Liquidity also dries up as many investors rush to exit positions at once, exacerbating the drop in stock prices. Reduced liquidity renders the market inefficient and risky.

The crisis and stock market turmoil often spread rapidly from the systemic risk event to other related markets or countries. Investors sell indiscriminately across markets due to a “flight to safety”. This contagion amplifies the crisis and its impact. A major systemic crisis damages the overall economy by hurting lending, consumer confidence, and growth. This adversely impacts corporate profits and cash flows, ultimately dragging down stock prices and returns for years. The economic effects of systemic crises on stocks persist for a long time.

Does Systemic Risk Affect the Economy?

Yes, systemic risk can have a major impact on the overall economy. Systemic crises often originate in the financial system, whether in banking, markets or institutions. The turmoil leads to a drop in asset prices, a lack of liquidity, and market inefficiencies. This hampers the ability of the financial system to provide lending and hurts market confidence. This negatively impacts economic growth. Banks become risk-averse during a crisis and are less willing to lend. They also experience losses and funding strains.

This causes a drop in credit supply in the economy especially for households and businesses. The credit crunch damages economic activity and spending. Consumers and businesses cut back spending and investment in response to the heightened uncertainty and negative wealth effects from falling asset prices during a crisis. This drop in aggregate demand slows down the economy. Crises spread from one sector or region to others through ripple effects. As the crisis expands, more parts of the economy are affected through spillovers. This makes the economic impact broader and more severe.

Governments and central banks intervene aggressively to stem the crisis by providing stimulus, liquidity, and bailouts. This expansion of the government’s role can create inefficiencies and also weigh on public finances in the long run. Systemic crises tend to have prolonged effects on the economy due to a sustained drop in demand and credit, as well as the time taken for markets and confidence to recover. Rebuilding balance sheets also takes many years. All this causes a long, drawn-out economic hardship and slow recovery.

Is systemic risk the same as systematic risk?

No, systemic risk and systematic risk are not the same. Systemic risk refers to the risk that failures in one part of a highly interconnected system could lead to uncontrollable cascades of defaults and damages, posing dangers to the system as a whole. It arises from interlinkages and interdependencies in the system. For example, the failure of Lehman Brothers posed a systemic risk to the financial system. Systematic risk refers to the risk that affects the entire market or segment. It refers to risks that influence a large proportion of stocks in a market or industry. For example, risks like inflation, recession, geopolitical events, natural disasters, etc. are sources of systematic risk that affect the overall stock market and economy.

What is the difference between Systemic Risk and Systematic Risk?

Below is a tabular comparison of differences between systemic risk and systematic risk.

CharacteristicSystemic RiskSystematic Risk
DefinitionThe risk that a company- or industry-level risk could trigger a huge collapse.The risk inherent to the entire market, is attributable to a mix of factors including economic, socio-political, and market-related events.
CauseEvents such as a financial crisis, natural disaster, or war.Events such as changes in interest rates, inflation, or economic growth.
ImpactCan lead to a widespread economic downturn.Can impact the value of all assets in the market.
MagnitudeCan be very large.Can be moderate to large.
PredictabilityDifficult to predict.More predictable than systemic risk.
MitigationCan be mitigated by government intervention and financial regulation.Can be mitigated by diversification and risk management techniques.
What is the difference between Systemic Risk and Unsystematic Risk?

Systematic risk also referred to as market or not diversifiable risk, refers to any threat affecting an entire market instead of just one security or asset. This type of risk often stems from macroeconomic forces like changes in interest rates, inflation rates, or economic growth rates that cannot be reduced through diversifying with several assets. Furthermore, systematic risks cannot be offset through diversifying across various assets in an investment portfolio.

Unsystematic risk, also referred to as specific or diversifiable risk, is a risk that is specific to a security or asset. This type of risk often arises due to factors specific to an industry such as product recalls, natural disasters, or management changes that impact only certain assets within an investment portfolio. Unsystematic risks can be reduced by diversifying your portfolio by holding multiple types of investments – unlikely all assets in one portfolio will be adversely impacted by an event of similar unsystematic nature.

Arjun Remesh

Head of Content

Arjun is a seasoned stock market content expert with over 7 years of experience in stock market, technical & fundamental analysis. Since 2020, he has been a key contributor to Strike platform. Arjun is an active stock market investor with his in-depth stock market analysis knowledge. Arjun is also an certified stock market researcher from Indiacharts, mentored by Rohit Srivastava.

Shivam Gaba

Reviewer of Content

Shivam is a stock market content expert with CFTe certification. He is been trading from last 8 years in indian stock market. He has a vast knowledge in technical analysis, financial market education, product management, risk assessment, derivatives trading & market Research. He won Zerodha 60-Day Challenge thrice in a row. He is being mentored by Rohit Srivastava, Indiacharts.

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