What is 'Systemic Risk'

Systemic risk is 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 to be a systemic risk are called "too big to fail." These institutions are large relative to their respective industries or make up a significant part of the overall economy. A company highly interconnected with others is also a source of systemic risk. Systemic risk should not be confused with systematic risk; systematic risk relates to the entire financial system.

BREAKING DOWN 'Systemic Risk'

The federal government uses systemic risk as a justification to intervene in the economy. The basis for this intervention is the belief that the 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, fully known as Dodd-Frank Wall Street Reform and Consumer Protection Act, introduced an enormous set of new laws that are supposed to prevent another Great Recession from occurring by tightly regulating key financial institutions to limit systemic risk. There has been much debate about whether changes need to be made to the reforms to facilitate the growth of small business.

Examples of Systemic Risk

Lehman Brothers’ size and integration into the U.S. economy made it a source of systemic risk. When the firm collapsed, it created problems throughout the financial system and the economy. Capital markets froze up while businesses and consumers could not get loans, or could only get loans if they were extremely creditworthy, posing minimal risk to the lender. (For more, see: The collapse of Lehman Brothers: A case study.)

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 (RMBS) 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 have caused numerous other financial institutions to collapse as well. (To learn more about how AIG survived the financial crisis, see: Falling Giant: A Case Study of AIG.)

RELATED TERMS
  1. Lehman Brothers

    Lehman Brothers was a global financial services firm whose bankruptcy ...
  2. Lehman Brothers Mortgage-Backed ...

    The Lehman Brothers Mortgage-Backed Securities (MBS) index is ...
  3. Financial System

    A financial system can be defined at the global, regional or ...
  4. Optimization

    Optimization, in the context of technical analysis, is the process ...
  5. Operational Risk

    Operational risk summarizes the risks a company undertakes when ...
  6. Too Big To Fail

    "Too big to fail" is a term for a business that has become so ...
Related Articles
  1. Investing

    AIG Stock Trades Ex-Dividend Tuesday (AIG)

    AIG will send its dividend payment on Dec. 22 to shareholders of record as of Dec. 8.
  2. Investing

    AIG Stock Falls After Q1 Earnings Plunge 47% (AIG)

    Despite its massive buyback of $870 million of its shares stock through Monday, AIG stock has been under pressure for most of the year.
  3. Insights

    AIG's Turnaround Success Breeds $100 Million Lawsuit (AIG)

    Former AIGFP employees involved in Credit Default Swap creation are suing for $100 million in unpaid bonuses.
  4. Insights

    AIG CEO Peter Hancock Plans to Resign

    AIG's CEO steps down in a move one analyst calls a "significant positive."
  5. Insights

    Top 5 Companies Owned by AIG

    AIG is one of the largest insurance companies in the world, with dozens of companies under its umbrella. Find out about the top five companies owned by AIG.
  6. Investing

    Why The Lehman Brothers Collapse Still Haunts Us

    Today is the eighth anniversary of the Lehman collapse, an event that sent the global economy hurtling towards an economic crisis.
  7. Insights

    Could AIG or MetLife No Longer Be Too Big To Fail?

    The Treasury Department meets to address the 'too big to fail' categorization of nonbank lenders.
  8. Insights

    The New Global Banking Regulations To Avert Future Crisis

    These are the types of policies that are being developed to minimize the risks posed to the global financial system by banks which are too big to fail.
  9. Investing

    AIG Sells United Guaranty for $3.4 Billion

    Sprawling insurance giant American International Group (NYSE: AIG), under pressure from a pair of activist investors to slim down, has reached a deal to sell its United Guaranty mortgage insurance ...
RELATED FAQS
  1. What are the primary sources of market risk?

    Learn about market risk and the four primary sources of market risk including equity, interest rate, foreign exchange and ... Read Answer >>
  2. What are the different sources of business risk?

    Explore the various sources of business risk for companies and learn how critical risk management is to a company's financial ... Read Answer >>
  3. What are the major categories of financial risk for a company?

    Examine four major categories of financial risk for a business that represent potential problems that a company may have ... Read Answer >>
  4. What major laws regulating financial institutions were created in response to the ...

    Read about the major federal responses to the financial crisis of 2008, such as the Dodd-Frank Wall Street Reform Act and ... Read Answer >>
  5. How does market risk differ from specific risk?

    Learn about market risk, specific risk, hedging and diversification, and how the market risk of assets differs from the specific ... Read Answer >>
Trading Center