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. Know Your Client - KYC

    A standard form in the investment industry that ensures investment ...
  6. Risk Capital

    Investment funds allocated to speculative activity. Risk capital ...
Related Articles
  1. How do I judge a mutual fund's performance?
    Fundamental Analysis

    How do I judge a mutual fund's performance?

  2. Systematic Risk
    Investing

    Systematic Risk

  3. Using Normal Distribution Formula To ...
    Investing Basics

    Using Normal Distribution Formula To ...

  4. How To Research Volatile Stocks
    Trading Strategies

    How To Research Volatile Stocks

Hot Definitions
  1. Hyperinflation

    Extremely rapid or out of control inflation. There is no precise numerical definition to hyperinflation. Hyperinflation is ...
  2. Gross Rate Of Return

    The total rate of return on an investment before the deduction of any fees or expenses. The gross rate of return is quoted ...
  3. Debit Spread

    Two options with different market prices that an investor trades on the same underlying security. The higher priced option ...
  4. Leading Indicator

    A measurable economic factor that changes before the economy starts to follow a particular pattern or trend. Leading indicators ...
  5. Wage-Price Spiral

    A macroeconomic theory to explain the cause-and-effect relationship between rising wages and rising prices, or inflation. ...
  6. Accelerated Depreciation

    Any method of depreciation used for accounting or income tax purposes that allows greater deductions in the earlier years ...
Trading Center