Systemic Risk Definition
Systemic Risk is the probability or risk of an event that could trigger the downfall of an entire industry or an economy. It happens when capital borrowers like banks, big companies, and other financial institutions lose capital providers’ trust like depositors, investors, and capital markets, etc. This type of risk cannot be gauged or quantified, but strict measures can be taken to manage and regulate it. In the 2008 financial crisis, systemic risk was one of the major contributing factors.
Example of Systemic Risk
One of the recent examples is the 2007-08 financial crisis, which started due to trouble in the subprime mortgage market in the U.S and the collapse of Lehman brother Inc. The collapse of this big company led to the liquidity crunch which speeded to all the credit and financial market and resulted in economic crisis or depression in the U.S.
The recession resulted in a global fall in trade and investment, sovereign debts crisis, recession in other advanced economies including Europe, and finally the great recession of 2007-08 which only cleared out in late 2009.
Types of Systemic Risk
- Banking Sector Panics: This refers to the crisis in the banking sector due to depositors withdrawing more money than they need. This generally happens when they see other people withdrawing money in the economy.
- Fall in Asset Prices: It means a decline in asset prices, like housing and stocks etc., could lead to triggering systemic risk.
- Contagion: This type of systemic risk happens when the collapse of one distressed financial institution led to the collapse of others as well, like in the 2008 economic crisis.
After the 2007-08 global recession, financial regulators across the world started focusing on decreasing the vulnerability factor of organizations to alike circumstances. For these they took the following steps:
- They created certain rules and requirements that an organization should be complied with if it met certain criteria i.e. firewall or protection to prevent outright damage due to systemic risk.
- They emphasized the importance of prudential regulations and also developed strict macro as well as micro-economic policies that the organizations should comply with.
- Macroeconomic policies cover the total market or economy as a whole while micro-economic policies regulate individual financial institutions like banks, lenders, insurance companies, mortgage markets, etc.
- It reduces the benefit of the diversification in the market; it is also sometimes known as un-diversifiable risk.
- Financial organizations are more vulnerable to systemic risk than other sectors or industries.
- The small occurrence of an event can lead to the collapse of the entire economy or market.
- Systemic risk if not prevented or regulated induces financial crisis and depression as it did in the 2007-08 financial crisis.
The prevention of systemic risk is taken care of by the financial regulators across the world after the 2007-2008 financial crisis. They took the following steps to ensure that the economy can be saved from similar kinds of events in the future:
- They formulated robust and strict micro as well as macroeconomic policies for banks and other financial institutions.
- Basel III accord came into being following the 2008 depression which was introduced particularly to mitigate the risk for the banking sector by asking them to maintain the required leverage ratio and reserve capital in hand.
- They also created other firewalls and restrictions to reduce the vulnerability of the economy as a whole towards systemic risk.
This has been a guide to Systemic Risk and its definition. Here we discuss its overview, types, examples, causes and its impact. You can learn more about finance from the following articles –