Systemic Risk

AAA

DEFINITION of 'Systemic Risk'

The possibility that an event at the company level could trigger severe instability or collapse an entire industry or economy. Systemic risk was a major contributor to the financial crisis of 2008. Companies considered a systemic risk are called “too big to fail.” These institutions are very large relative to their respective industries or make up a significant part of the overall economy. A company that is highly interconnected with others is also a source of systemic risk. Systemic risk should not be confused with systematic risk.

INVESTOPEDIA EXPLAINS 'Systemic Risk'

Federal government uses systemic risk as a justification to intervene in the economy. The basis for this intervention is the belief that the federal government can reduce or minimize the ripple effect from a company-level event through targeted regulations and actions. For example, the Dodd-Frank Act of 2010, an enormous set of new laws, is supposed to prevent another Great Recession from occurring by tightly regulating key financial institutions to limit systemic risk.

Lehman Brothers’ size and integration into the U.S. economy made it a source of systemic risk. When the firm collapsed, this event created problems throughout the financial system and the economy. Capital markets froze up while businesses and consumers couldn’t get loans, or could only get loans if they were extremely creditworthy, posing minimal risk to the lender.

Simultaneously, AIG was also suffering serious financial problems. Like Lehman, AIG’s interconnectedness with other financial institutions made it a source of systemic risk during the financial crisis. AIG’s portfolio of assets tied to subprime mortgages and its participation in the residential mortgage-backed securities market through its securities-lending program led to collateral calls, a loss of liquidity and a downgrade of AIG’s credit rating when the value of those securities dropped. While the U.S. government did not bail out Lehman, it decided to bail out AIG with loans of more than $180 billion, preventing the company from going bankrupt. Analysts and regulators believed that an AIG bankruptcy would cause numerous other financial institutions to collapse as well.

 

RELATED TERMS
  1. Ulcer Index - UI

    An indicator developed by Peter G. Martin and Byron B. McCann ...
  2. Risk-On Risk-Off

    An investment setting in which price behavior responds to, and ...
  3. Risk Seeking

    The search for greater volatility and uncertainty in investments ...
  4. State Street Investor Confidence ...

    An index that measures investor confidence by looking at actual ...
  5. Regret Theory

    A theory that says people anticipate regret if they make a wrong ...
  6. Risk Management

    The process of identification, analysis and either acceptance ...
RELATED FAQS
  1. What percentage of a diversified portfolio should large cap stocks comprise?

    The percentage of a diversified investment portfolio that should consist of large-cap stocks depends on an individual investor's ... Read Full Answer >>
  2. How attractive is the food and beverage sector for a growth investor?

    The food and beverage sector is attractive for a growth investor. The sector's high degree of volatility means it tends to ... Read Full Answer >>
  3. How attractive is the retail sector for a growth investor?

    Retail is an attractive sector for a growth investor due to its propensity for turning in bigger-than-average gains when ... Read Full Answer >>
  4. What sectors have higher exposure to inherent risk?

    Sectors with complex accounting requirements, such as financial services, banking, energy and utilities, have high inherent ... Read Full Answer >>
  5. What percentage of a diversified portfolio should be invested in the telecommunications ...

    While ideal portfolio structure varies wildly based on factors such as investing style and risk tolerance, the average investor ... Read Full Answer >>
  6. What are some examples of high yield bonds?

    Issuers of high-yield bonds can be firms from virtually any market sector. The noninvestment grade rating of their bond issues ... Read Full Answer >>
Related Articles
  1. Active Trading Fundamentals

    Five Biggest Obstacles Facing First-Year Traders

    Address these five obstacles and you'll make significant progress as a first-year trader.
  2. Entrepreneurship

    Risks Associated With Government Contracts

    Government contracts can be rewarding, but they also come with a variety of risks.
  3. Investing

    4 Structured Product Types Wealthy Clients Love

    High-net-worth investors find structured products appealing for a variety of reasons. Here's a look at four types.
  4. Professionals

    Advisors: Start Coaching Clients from the Start

    Behavioral coaching is vital to help investors stick to plan during market turbulence. Start coaching early and maintain it through the relationship.
  5. Trading Systems & Software

    Make Money Through Risk Arbitrage Trading

    Risk arbitrage provides a valuable trading strategy for M&A or other corporate actions eligible stocks. Investopedia explains how it works.
  6. Trading Strategies

    Adjust Market Strategies To Elevated Risk

    Improve returns by adapting trading strategies to changing market conditions.
  7. Trading Strategies

    Pros And Cons Of Paper Trading

    Most market novices should paper trade for a considerable amount of time, despite key drawbacks.
  8. Stock Analysis

    Invest Here Now: The Hottest Sectors of 2014-15

    These 10 industries have made investors a lot of money over the past year. Is there still room to run?
  9. Professionals

    What Does an Ideal Retirement Portfolio Look Like?

    The "ideal" portfolio can differ from one investor to another depending on many factors, but some themes hold true no matter what.
  10. Mutual Funds & ETFs

    ETF Analysis: iShares FTSE/Xinhua China 25

    Learn about iShares FTSE/Xinhua China 25 and its asset allocation and how investing in this fund comes with heightened risks of emerging market risk.

You May Also Like

Hot Definitions
  1. Bogey

    A buzzword that refers to a benchmark used to evaluate a fund's performance. The benchmark is an index that reflects the ...
  2. Xetra

    An all-electronic trading system based in Frankfurt, Germany. Launched in 1997 and operated by the Deutsche Börse, the Xetra ...
  3. Nuncupative Will

    A verbal will that must have two witnesses and can only deal with the distribution of personal property. A nuncupative will ...
  4. OsMA

    An abbreviation for Oscillator - Moving Average. OsMA is used in technical analysis to represent the variance between an ...
  5. Investopedia

    One of the best-known sources of financial information on the internet. Investopedia is a resource for investors, consumers ...
  6. Unfair Claims Practice

    The improper avoidance of a claim by an insurer or an attempt to reduce the size of the claim. By engaging in unfair claims ...
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!