Systemic Risk

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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.

BREAKING DOWN '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.

 

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