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. Know Your Client - KYC

    A standard form in the investment industry that ensures investment ...
RELATED FAQS
  1. How is a short call used in a covered call option strategy?

    In a covered call strategy, a trader sells a short call at a strike price above the current price of the underlying stock. ... Read Full Answer >>
  2. How is a short call used in a naked call writing option strategy?

    Selling Naked Calls A trader sells a naked call short at a strike price generally above the market for a premium amount. ... Read Full Answer >>
  3. How is the expected market return determined when calculating market risk premium?

    In some cases, brokerage firms provide an expected market rate of return based on an investor's portfolio composition, risk ... Read Full Answer >>
  4. How can I use risk return tradeoff to determine my risk tolerance and investment ...

    An investor can use the risk-return tradeoff to determine what type of assets to include in a portfolio. The risk-return ... Read Full Answer >>
  5. Why is risk return tradeoff important in designing a portfolio?

    The risk-return tradeoff determines how aggressive an investor wants to be with the assets included in the portfolio. An ... Read Full Answer >>
  6. How do modern companies assess business risk?

    Before a business can assess or mitigate business risk, it must first identify probable or likely risks to its bottom line. ... Read Full Answer >>
Related Articles
  1. Professionals

    Worried About Stocks? Try on Convertibles

    Convertibles are a good hedge against equity market risk (if you're o.k. with losing a bit of upside potential).
  2. Professionals

    When Couples Have Different Risk Appetites

    Communication, compromise and frequent monitoring will lead to successful investing for spouses with different risk tolerances.
  3. Professionals

    How Retirees Should Approach Interest Rate Hikes

    Here's what retirees can do if interest rates rise.
  4. Fundamental Analysis

    What an Investment Policy Statement Looks Like

    The anatomy of an Investment Policy Statement.
  5. Trading Strategies

    How To Cover Your Bases After Making A Trade

    Follow up your trade entry with these time-tested risk management strategies.
  6. Active Trading Fundamentals

    Four Steps To Manage A Downturn In The Market

    A few simple adjustments could end your losing streak as soon as it begins.
  7. Professionals

    Tips for Assessing a Client's Risk Tolerance

    Determining a client’s risk tolerance is a critical piece of the puzzle in designing and appropriate asset allocation.
  8. Mutual Funds & ETFs

    The EMAG Emerging Mkts Bond ETF: Worth the Risk?

    The Market Vectors Emerging Markets Aggregate Bond ETF (EMAG) might offer long-term rewards, but is now the best time to jump in?
  9. Active Trading Fundamentals

    Reading And Adapting To Market Performance

    Performance that aligns with broad market direction exposes a major strategic weakness.
  10. Investing

    Feeling Risk-Averse? Consider These Investments

    These investments offer risk-averse investors resiliency to bear markets while paying sustainable dividends or interest.

You May Also Like

Hot Definitions
  1. Multicurrency Note Facility

    A credit facility that finances short- to medium-term Euro notes. Multicurrency note facilities are denominated in many currencies. ...
  2. National Currency

    The currency or legal tender issued by a nation's central bank or monetary authority. The national currency of a nation is ...
  3. Treasury Yield

    The return on investment, expressed as a percentage, on the debt obligations of the U.S. government. Treasuries are considered ...
  4. Bund

    A bond issued by Germany's federal government, or the German word for "bond." Bunds are the German equivalent of U.S. Treasury ...
  5. European Central Bank - ECB

    The central bank responsible for the monetary system of the European Union (EU) and the euro currency. The bank was formed ...
  6. Quantitative Easing

    An unconventional monetary policy in which a central bank purchases private sector financial assets in order to lower interest ...
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!