Systemic Risk

Sometimes, the biggest threats to our financial stability are outside of our direct control. In this post, we dive into the basics of systemic risk and how it can affect entire financial systems by exploring the 2008 financial crisis.

Talking Points:

• What is Systemic Risk?

• Systemic Dangers

• The 2023 Information Run

• Mitigation and Prevention

• So What?

What is Systemic Risk?

Systemic risk is the risk of an economy's complete or partial failure due to the collapse of a financial entity. A financial entity, such as a company, industry, or institution, has higher systematic risk if they have a historically significant influence on the economy or are strongly interconnected to other entities. This risk may result from capital providers (ex. investors, depositors, capital markets) losing trust in an entity, resulting in a cascading financial downturn.

Systemic Dangers

Financial institutions, such as banks are not independent entities. Instead, we can imagine them as a network of knit-together webs of connections. They exchange short and long-term loans and cover each other’s losses in order to ensure none go under. However, if a bank experiences a significant loss that renders them insolvent, meaning they don’t have enough capital to cover the loss and pay off debts, the responding banks nearby it in its web of connections, will be dragged along with the initial bank into collapse. Larger institutions that fail, and subsequently pull many other institutions into ruin with them through their farther-reaching interconnections, can have such severe impact on the industry as to bring the economy into recession.

The 2023 Information Run

On March 8, 2023, Silicon Valley Bank (SVB) announced losses in their assets, which caused a panic where investors quickly withdrew their money. The unexpected closure of SVB, just two days later, brought about the fear that other banks might soon experience similar losses. Globally, investors started selling their bank shares, resulting in a crash in the banking industry.

Information runs are an example of a systemic risk that happens when investors make an assumption of the whole financial system’s health based on just a small portion of that system. It is an understandable assumption since banks in the same sector often make similar investment decisions. Though, in a large-scale panic, it can have dire effects on the system itself as well as others around it. 

Mitigation and Prevention

The risk of systemic risk risks risking the failure of an industry or even the economy. That is to say, the ripple effect from systematic risk can lead to a recession and therefore is an important danger for legislators to prevent and mitigate.

In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act created the Office of Financial Research (OFR), a subsect of the US Treasury, to look out for systemic failures in the global market. In addition, the Federal Deposit Insurance Corporation (FDIC) is authorized to assist failing entities with federal funds to prevent total collapse. 

Improved transparency and further disclosure of financial risks institutions take can allow investors to make more informed decisions. Education and coordinated action of investors may also create more confidence in their capital holders. 

Ironically, failed banks have often been replaced by larger consolidations, which have higher systemic risk, possibly fostering a new cycle of economic crises. 

So What?

Understanding systemic risk is the first step in understanding the fundamentals underlying all investment decisions and risk management. This post has hopefully emphasized to you how interconnected every industry, institution, and company is. A solid grasp of this inherent concept of risk lets us also expand to risks that apply to you as an individual, which you have influence over.

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Written by Ethan Qian-Tsuchida

Newton South Hight School student

Interests in finance, economics, risk management, and teaching others about fun topics to make the world of finance and economics approachable.

LinkedIn - https://www.linkedin.com/in/ethan-qian-tsuchida-a0a7991b9/ 

Email - ethan.qiantsuchida@gmail.com