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. Risk Management

    The process of identification, analysis and either acceptance ...
  6. Know Your Client - KYC

    A standard form in the investment industry that ensures investment ...
RELATED FAQS
  1. How does the risk of investing in the electronics sector compare to the broader market?

    The risk of investing in the electronics sector closely approximates the risk of investing in the broader market. The electronics ... Read Full Answer >>
  2. What is a "non linear" exposure in Value at Risk (VaR)?

    The value at risk (VaR) is a statistical risk management technique that determines the amount of financial risk associated ... Read Full Answer >>
  3. What percentage of a diversified portfolio should be exposed to the aerospace sector?

    Diversification is an effective portfolio management technique used to prevent a sharp decline in an individual company or ... Read Full Answer >>
  4. What is backtesting in Value at Risk (VaR)?

    The value at risk is a statistical risk management technique that monitors and quantifies the risk level associated with ... Read Full Answer >>
  5. How does behavioral economics treat risk aversion?

    The findings of behavioral economists regarding risk aversion can best be summarized by the phrase, "losses loom larger than ... Read Full Answer >>
  6. What's the difference between a confidence level and a confidence interval in Value ...

    The value at risk (VaR) uses both the confidence level and confidence interval. A risk manager uses the VaR to monitor and ... Read Full Answer >>
Related Articles
  1. Investing Basics

    Manage Investments And Modern Portfolio Theory

    Modern Portfolio Theory suggests a static allocation which could be detrimental in declining markets, making it necessary for continuous risk assessment. Downside risk protection may not be the ...
  2. Active Trading Fundamentals

    Are You Ready To Be A Professional Trader?

    Here's help in making the quantum leap from novice to crackerjack trader.
  3. Investing

    Are Women Steadier Long-Term Investors?

    We look at the differences in behavior between male and female and found that women are steadier customers when it comes to following allocation advice.
  4. Investing Basics

    Understanding Risk Averse Investing

    Risk averse describes a low level of risk an investor is willing to accept on his investments. An investor who is risk averse prefers little risk and is willing to accept a lower return because ...
  5. Active Trading Fundamentals

    20 Rules To Trade More Professionally

    Break free from the pack and join the professional minority with an approach that raises your odds for long term prosperity.
  6. Investing

    Ten Worst Mistakes Beginner Investors Make

    Here are the ten worst mistakes beginning investors make.
  7. Trading Strategies

    Trader Rookie Mistakes: Avoid Them While You Can!

    These 10 common trading mistakes can rob capital and undermine confidence.
  8. Fundamental Analysis

    Examples To Understand The Binomial Option Pricing Model

    Binomial option pricing model, based on risk neutral valuation, offers a unique alternative to Black-Scholes. Here are detailed examples with calculations using Binomial model and explanation ...
  9. Investing

    Understanding Market Risk Premium

    Market risk premium is equal to the expected return on an investment minus the risk-free rate. The risk-free rate is the minimum rate investors could expect to receive on an investment if it ...
  10. Trading Strategies

    Cardinal Points For Mapping a Trading Route

    A successful trading plan addresses four key elements of trading: prediction, timing, volatility and risk.

You May Also Like

Hot Definitions
  1. Fiduciary

    1. A person legally appointed and authorized to hold assets in trust for another person. The fiduciary manages the assets ...
  2. Expected Return

    The amount one would anticipate receiving on an investment that has various known or expected rates of return. For example, ...
  3. Carrying Value

    An accounting measure of value, where the value of an asset or a company is based on the figures in the company's balance ...
  4. Capital Account

    A national account that shows the net change in asset ownership for a nation. The capital account is the net result of public ...
  5. Brand Equity

    The value premium that a company realizes from a product with a recognizable name as compared to its generic equivalent. ...
Trading Center