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What is Systemic Risk?

A-Level, IB
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 29 Jan 2023

Systemic risk became a key concept during the Global Financial Crisis (GFC). Systemic risk is the possibility that an event at the micro level of an individual bank / insurance company for example could then trigger instability or collapse an entire industry or economy.

What is Systemic Risk?

Systemic risk refers to the potential for a failure or crisis in one or more parts of the financial system to spread and cause widespread disruption to the entire system. It can be defined as the risk that an event in one part of the financial system will trigger a chain reaction, leading to a widespread failure of the financial system. This can happen when an event causes a large number of financial institutions or markets to become illiquid or insolvent, which can lead to a lack of confidence in the system and a decrease in the availability of credit.

There are several ways that systemic risk can manifest in financial markets:

  • Contagion: This occurs when a crisis in one part of the financial system spreads to other parts of the system, causing a widespread failure. For example, a crisis in the mortgage market in the United States in 2007 and 2008 led to a global financial crisis.
  • Interconnectedness: Financial markets and institutions are highly interconnected, which means that a failure in one institution or market can have a knock-on effect on other institutions and markets. For example, if a large bank fails, it can lead to a lack of confidence in the banking system and a decrease in the availability of credit.
  • Complexity: The financial system is becoming increasingly complex, with a large number of different financial products and markets. This can make it difficult to understand the potential consequences of a failure in one part of the system.
  • Complex regulations: The regulations of financial markets, institutions and products are becoming increasingly complex and can make it difficult to identify and mitigate systemic risks.

To mitigate systemic risk, regulators have implemented stricter regulations on financial institutions and markets, to ensure that they are able to withstand shocks and that they have the capacity to absorb losses in case of market downturns. Central Banks also have tools to monitor and act upon systemic risk, such as macro-prudential tools and stress tests.

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