Systemic Risk

Overview

Systemic risk refers to the possibility that an event at the company level could trigger severe instability or collapse an entire industry or economy. It is the risk of a major failure of a financial system, whereby a crisis occurs when providers of capital lose trust in the users of capital. Systemic risk has been associated with a bank run which occurs when a large number of customers withdraw their deposits simultaneously due to fears that the bank might become insolvent. As depositors withdraw their deposits, the likelihood of default increases, thereby prompting more withdrawals. This can destabilize the bank to the point where it runs out of cash and thus faces sudden bankruptcy. To learn more about bank runs, click here.

Causes of Systemic Risk

Systemic risk can be caused by a number of factors, including economic recessions, natural disasters, and financial crises. The collapse of a single entity or cluster of entities can cause a cascading failure, which could potentially bankrupt or bring down the entire system. This is different from systematic risk, which is the risk inherent to the entire market or market segment.

Types of Systemic Risk

Systemic risk can be broken down into several types:

Systematic Risk

Systematic risk, also known as market risk, is inherent to the entire market or market segment. It cannot be eliminated through diversification. It includes interest rate risk, inflation risk, currency risk, liquidity risk, and political risk.

Idiosyncratic Risk

Idiosyncratic risk, also known as unsystematic risk, is unique to a specific company or industry. It can be reduced through diversification. It includes business risk, financial risk, and credit risk.

Aggregate Risk

Aggregate risk involves the exposure of a lender institution to particular sectors or industries. This risk can be mitigated by diversification of the loan portfolio.

Measurement of Systemic Risk

Systemic risk is difficult to measure because it involves unforeseen and often catastrophic events. However, several methods have been proposed:

CoVaR

CoVaR, or Conditional Value at Risk, measures the risk of an individual entity given distress in the financial system. It is a measure of systemic risk contribution of a single institution.

SRISK

SRISK, or Systemic Risk, measures the capital shortfall of a firm in a systemic crisis. It is a measure of systemic risk contribution of a single institution.

DIP

DIP, or Distress Insurance Premium, measures the insurance premium against systemic financial distress. It is a measure of systemic risk contribution of a single institution.

Mitigation of Systemic Risk

There are several ways to mitigate systemic risk:

Regulation

Financial regulation aims to maintain the integrity of the financial system. This includes regulatory oversight of financial institutions, setting standards for financial reporting, and enforcing laws against financial crime.

Diversification

Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. The rationale behind this technique is that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

Hedging

Hedging is an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security.