Quick definition Systemic risk is the danger that a failure in one part of the financial system triggers failures across the system. What it is When a large financial institution fails, it can trigger failures elsewhere. Institutions may have exposures to the failed institution (credit risk). Markets may seize up (liquidity risk). Panic may spread (confidence risk). The 2008 financial crisis demonstrated systemic risk: Lehman's failure triggered a cascade of failures and nearly collapsed the financial system. Why it matters Systemic risk is the reason for financial regulation and central bank intervention. Regulators prevent individual failures from becoming system-wide crises. Systemic risk is also why the largest financial institutions receive preferential treatment ("too big to fail"): their failure is deemed too dangerous to tolerate. Contagion Contagion is the spread of a crisis from one institution to others. Mechanisms include: - Direct exposure (holding debt from the failed firm) - Indirect exposure (interconnected customers or counterparties) - Market illiquidity (forced selling cascades) - Loss of confidence (panic) Circuit breakers Circuit breakers are designed to prevent systemic risk by halting trading during extreme market movements, preventing panic cascades. Regulation Regulators manage systemic risk by: - Requiring capital buffers - Limiting leverage - Testing resilience (stress testing) - Monitoring interconnections - Having resolution authority Practical example A major bank fails. The bank's creditors lose money. Other banks that lent to this bank lose money. Companies that relied on this bank's credit now can't access financing. Stock markets fall out of fear. This cascade is systemic risk. Regulators intervene (provide liquidity, guarantee deposits, take over the bank) to prevent the cascade. See also - Counterparty Risk - Contagion - Too Big to Fail - Regulatory Capital
