In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to the risk associated with any one individual entity, group or component of a system, that can be contained therein without harming the entire system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries". It refers to the risks imposed by interlinkages and interdependencies in a system or market, where the failure of a single entity or cluster of entities can cause a cascading failure, which could potentially bankrupt or bring down the entire system or market. It is also sometimes erroneously referred to as "systematic risk".
Explanation Systemic risk has been associated with a bank run which has a cascading effect on other banks which are owed money by the first bank in trouble, causing a cascading failure. As depositors sense the ripple effects of default, and liquidity concerns cascade through money markets, a panic can spread through a market, with a sudden flight to quality, creating many sellers but few buyers for illiquid assets. These interlinkages and the potential "clustering" of bank runs are the issues which policy makers consider when addressing the issue of protecting a system against systemic risk. Governments and market monitoring institutions (such as the U.S. Securities and Exchange Commission (SEC), and central banks) often try to put policies and rules in place with the justification of safeguarding the interests of the market as a whole, claiming that the trading participants in financial markets are entangled in a web of dependencies arising from their interlinkage. In simple English, this means that some companies are viewed as too big and too interconnected to fail. Policy makers frequently claim that they are concerned about protecting the resiliency of the system, rather than any one individual in that system. Systemic risk arises because of the interaction of market participants, and therefore can be seen as a form of endogenous risk. The risk management literature offers an alternative perspective to notions from economics and finance by distinguishing between the nature of systemic failure, its causes and effects, and the risk of its occurrence. It takes an "operational behaviour" approach to defining systemic risk of failure as: "A measure of the overall probability at a current time of the system entering an operational state of systemic failure by a specified time in the future, in which the supply of financial services no longer satisfies demand according to regulatory criteria, qualified by a measure of uncertainty about the system's future behaviour, in the absence of new mitigation efforts." This definition lends itself to practical risk mitigation applications, as demonstrated in recent research by a simulation of the collapse of the Icelandic financial system in circa 2008. Systemic risk should not be confused with market or price risk as the latter is specific to the item being bought or sold and the effects of market risk are isolated to the entities dealing in that specific item. This kind of risk can be mitigated by hedging an investment by entering into a mirror trade. Insurance is often easy to obtain against "systemic risks" because a party issuing that insurance can pocket the premiums, issue dividends to shareholders, enter insolvency proceedings if a catastrophic event ever takes place, and hide behind limited liability. Such insurance, however, is not effective for the insured entity. One argument that was used by financial institutions to obtain special advantages in bankruptcy for derivative contracts was a claim that the market is both critical and fragile. Systemic risk can also be defined as the likelihood and degree of negative consequences to the larger body. With respect to federal financial regulation, the systemic risk of a financial institution is the likelihood and the degree that the institution's activities will negatively affect the larger economy such that unusual and extreme federal intervention would be required to ameliorate the effects. A general definition of systemic risk which is not limited by its mathematical approaches, model assumptions or focus on one institution, and which is also the first operationalizable definition of systemic risk encompassing the systemic character of financial, political, environmental, and many other risks, was put forth in 2010. The Systemic Risk Centre at the London School of Economics is focused on the study of systemic risk. It finds that systemic risk is a form of endogenous risk, hence frustrating empirical measurements of systemic risk.
Measurement
TBTF/TCTF According to the Property Casualty Insurers Association of America, there are two key assessments for measuring systemic risk, the "too big to fail" (TBTF) and the "too (inter)connected to fail" (TCTF or TICTF) tests. First, the TBTF test is the traditional analysis for assessing the risk of required government intervention. TBTF can be measured in terms of an institution's size relative to the national and international marketplace, market share concentration, and competitive barriers to entry or how easily a product can be substituted. Second, the TCTF test is a measure of the likelihood and amount of medium-term net negative impact to the larger economy of an institution's failure to be able to conduct its ongoing business. The impact is measure beyond the institution's products and activities to include the economic multiplier of all other commercial activities dependent specifically on that institution. The impact is also dependent on how correlated an institution's business is with other systemic risks.
Too big to fail
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