What is Systemic Risk?

Systemic risk is risk to the “system” in some way. In the financial services world, it is often defined in one of two ways:

Systemic risk can be defined in two ways
  • The risk of contagion, where¬†failure of an entity leads to distress or failures of others [micro prudential]
  • The risk of an event that can trigger serious consequences for the real economy. [macro prudential]

If you are a narrowly focussed prudential regulator, you might be concerned with the micro-prudential view. After the Global Financial Crisis acted as a reminder of the Great Depression, the impact on the real economy of failures within the financial sector now cannot be ignored.

Individual entities can fail and, possibly, be well managed through their failure to limit the financial impact on customers. The failure of several entities could similarly be limited in the breadth of its impact. Mass job losses, decline in GDP, failure of businesses outside the financial sector and other leakage into the real economy has costs measured as percentage of GDP foregone, likely over several years. Inevitably this a much larger hit than the failure of even several entities.

I don’t view this as a choice, either the micro view or the macro view. The failure of several entities is more likely to drive real economy effects. As I’ll discuss when in a later post when I talk about “Tsunamis”, no individual entity has to fail for their to real economy implications. Similarly, the failure of several financial services entities that doesn’t have significant real economy impacts is clearly undesirable.

The most useful view is of both of these as systemic risks and outcomes to be avoided.