Systemic Risk: Definition, Example, and Prevention

Systemic Risk Definition
Systemic Risk: Definition, Example, and Prevention

Systemic risk is defined as the risk of potentially collapsing an economy. Systemic risk is a domino effect. A single event will start a ripple effect that causes a major economic crisis. 

Many economic crises are indeed the effect of systemic risk. A famous example of systemic risk is the 2008 stock market collapse. The economic crises in the recent decade have shown more light on systemic risk, and it has become a measure that is closely watched now. 

Systemic risk regulation is a critical aspect of an economy. It is carried out by the authorities, including governments. It is one of the few occasions where the government actually interferes in the economy. There are two schools of thought that are for and against this intervention.

 But, proper systemic risk management can often avoid an economic crisis where millions could lose their jobs, and the stock market would see declining numbers.

Let us learn more about systemic risk, its examples, and methods of prevention through this article.

What is a Systemic Risk?

Systemic risk is the risk of the collapse of an entire system that often starts with a single event. Systemic risk is unlike the risk associated with an individual stock or a company, where the risk is limited to the company and its investors or, at the utmost, the sector. Systemic risks have the potential to bring down even the largest of economies. 

Systemic failure is the predicted outcome of systemic risk. It is when a large economy or establishment of equal size collapses, creating an unmanageable catastrophe. 

The main cause of systemic is the interlinkage of the market. An economy and the market are often dependent on each other. No single part or portion of the market is unaffected by system-wide happenings. The stock markets are often the best example of this interlinkage and dependency. Stock markets all over the world often fall together. The majority of the companies listed in a stock market will have a bad time when there is a bear run. On the other hand, the market prices will mostly be rising during a bull run. This depicts dependency. At the same time, there could be occurrences when a company or two might face a downtrend due to internal factors. But most of the time, there will be a ripple effect that is seen in different magnitudes according to the situation. 

How do Systemic Risk works?

Systemic risk works by creating a ripple effect that starts from one outcome. Systemic risk affects the entire economy gradually. Let us take a hypothetical example to understand the scenario better. 

How do Systemic Risk works
How do Systemic Risk works?

Bigger companies pose more risk of systemic failure. Let us suppose in an oil-export-dependent country, there is a company that manages the lion’s share of oil export. Due to reasons other than performance (politics, internal conflict, corruption)., the company fails. 

Now, another company can take place eventually with the government’s help, but that action could take time. In the meantime, the entire economy could choke due to uncertainty and lack of income. This invariably creates a catastrophe in the economy.

Here, another factor to take notice is government intervention. The same may become necessary when a stalwart company fails; often, this can give the economy a chance to survive. 

How to prevent a Systemic Risk?

Systemic risk can be prevented by measures that the governments and the authorities. Important preventive measures include establishing effective oversight and regulation that monitors and acts upon the current risk, a solid macroeconomic management approach for systemic risk affecting the entire economy, and monetary, fiscal, and exchange rate measures that can mitigate the accumulation of economic imbalances.

We get the clearest picture of systemic risk during and after an economic crisis. This is because most economic crises are an affect effect of systemic risk. Hence, experts believe that the best course of action to reduce systemic risk is by taking steps to avoid an economic crisis. Experts are mostly of the opinion that crisis is a byproduct of systemic failure as well. Measures to avoid such a systemic failure can also reduce systemic risk. 

Governments should also have a crisis containment plan in place. Just like stock markets, the economy can often be unpredictable. But the after-effects of the same can be reduced by ensuring there is a plan to effectively manage the crisis at its root level. India’s management of economic crises that hit the world during the 90s could be an example. 

Authorities should increase macroeconomic and financial surveillance as well, experts believe. This can help the government see a crisis sprouting and dom needful to prevent it from growing. Government should also be able to provide supervision in the same with the help of the central bank. 

In short, systemic risk can be regulated by the right and constant intervention of the government. At the same time, the level of intervention has to be optimal, as over-intervention could often have negative effects. This is because the economy, most of the time, is best left untouched by an authority. 

What are examples of Systemic Risk?

The biggest example of a systemic risk causing an economic disruption is the 2007-08 economic crisis. The crisis is considered the most significant after the great depression, causing many their livelihood and harming most economies. But the whole event can be traced back to one systemic risk.

examples of Systemic Risk
How Recession of 2008-09 happened

The crisis happened due to excessive risk-taking by financial institutions related to mortgages. In short, financial institutions, in a way to attain more customers, give away home loans at a lower rate without much credit checking. The institutions initially gained from the same, but as time passed by, it became evident that many home loan takers would not be able to pay the loan back. When this fact started hitting the accounts, a crisis was born. The lenders were clueless about how to curtail the situation with real estate rates taking a nose dive.

This led to the collapse of Lehman Brothers, one of the biggest lenders. Unrooting such a mammoth company had a rippling effect that affected the whole global economy. This one single incident is believed to singlehandedly collapse multiple economies. The crisis and the recession that followed lasted almost 18 months.

How to calculate Systemic Risk?

Systemic risk is evaluated in terms of probability and consequence. Conventional risks are simply defined by their typical characteristics. Non-conventional ones, systemic risks are harder to identify.

Systemic risk is assessed by the susceptibility of a security’s performance to the general performance of the market. This susceptibility can be determined using the coefficient (beta). The coefficient is determined by reverting back the return of security against the market profit The approximate equation is as follows:

formula for systemic risk

RS is the yield on a specific security, while RM is the yield on the whole. β  is observed to be the coefficient of regression of RS on RM. The intercept term demonstrates the return of security independent of stock returns.

What are the instances when systemic risk can happen?

There are three primary factors that contribute to systemic risk – macroeconomic factors, social factors, and environmental factors.

Macroeconomic factors consist of different macroeconomic phenomena that could increase or decrease systematic risk. An example of such a macroeconomic factor is inflation. Inflation is an increase in prices due to the decreasing value of the currency. A higher level of inflation can negatively affect the economy and add to systemic risk.

Interest rates are another macroeconomic factor that is related to systemic risk. Higher interest rates may curtail money flow, affect the economy, and increase systemic risk.

Similarly, currency fluctuations also play a part. A weakening currency is often seen as a threat to a nation’s economy, increasing the systemic risk. 

Environmental factors have a crucial role in systemic risk as well. These have been neglected for years, but the world now understands the increasing importance of the environment in the world economy.

A very poignant example of such an environmental factor is climate change. Climate change is a result of many things, including the growth of nations, while neglecting the effect it has on nature. Climate change could bring about many disasters, which are huge systemic risks. For example, let us consider the case of a country that has many water bodies. One of the affect effects of climate change is the increasing number of floods. If such a country is hit with a major flood, the business would be disrupted completely, resulting in a collapse of the economy. 

Another huge systemic risk is diminishing natural resources. For example, oil. Most of the world’s transportation is still dependent on oil, including petrol and diesel. But is estimated that the world will run out of oil in the next 50 years. If that happens, and the world is underprepared for it, it could collapse the world economy. Ofcourse, the decline would be gradual, but the same can also cause many political tensions.

Finally, social factors also play a crucial role in systemic risk. One important example here is wars. Wars are conflicts between countries that disrupts the supply of goods and production. This can have a stark on the world economy. Recent wars are an example of this. These caused worldwide disruption of import and export, which hiked the prices of many products, including natural resources. Situations like these increase the systemic risk by a lot. 

Is systemic risk the same as a systematic risk?

No, systemic and systematic risks are both hazardous for an economy, but the causes of both and how they are managed are completely different. Systemic risk describes the risk of a major collapse in a particular industry or the border sector. At the same time, systematic risk is a broader risk that affects the overall market due to multiple factors.

What is the difference between Systemic Risk and Systematic Risk?

The major difference between the two is that systematic risk is one event. For instance, the collapse of Lehman Brothers is said to be the root cause of the economic crisis of 2008. Here, the single contributing factor is closure.

At the same time, for systematic risk, there are multiple factors. The recent crisis in Sri Lanka is an example of this. Here, there is no single factor that affects the economy but a handful of factors. Another famous example of the same is the economic crisis of 2000. Here, too, there is no one single factor but many factors that contributed to the situation. 

Below are some differences between systemic and systematic risk.

  • Systemic risk is the danger of a complete system failure, as opposed to the failure of specific elements. Systemic risk, on the other hand, refers to the inherent risk of the overall market or industry sector.
  • Systemic risks are difficult to foresee since it is frequently unclear how the failure of a financial organization or company would affect the economy as a whole. However, once discovered, the route of systemic risks is reasonably predictable. For instance, we understand how recessions or an increase in interest rates often affect the market and can consequently prepare.
  • Diversifying your portfolio can shield you against systemic threats. But systematic risk cannot be mitigated through diversification due to its breadth. Nonetheless, you can limit systematic risks with asset classes, such as a mix of real estate, cash, and stocks.

What is the difference between Systemic Risk and Unsystematic Risk?

Unsystematic risk refers to the risk of collapse of an industry or company due to multiple factors, while systemic risk refers to the risk of collapse of an economy that roots from one single factor. 

Unsystematic risk is a specific corporation’s risks, including those related to management, revenue, customer base, item recalls, labor disputes, and brand awareness.  This kind of risk is specific to an asset and is avoidable through diversification.

Unsystematic risk includes two types. Any internal elements influencing a company’s earnings and performance are considered business risks. Business risks can also be caused by external reasons that are unique to a particular company, such as product prohibition by the government.

The debt and equity of a firm are related to financial risk. A company’s debt-to-equity ratio may suffer if it incurs too much debt. A negative debt-to-equity ratio suggests that a business might be in financial trouble.

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