What is systemic risk
Systemic risk is the risk that a failure in one part of the financial system spreads and disrupts the whole system, not just individual firms or assets.
The cause is usually a firm, a market or a payment link that many others depend on. When it fails, losses pass from institution to institution through loans, collateral and confidence.
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Formal definition
Central banks and international bodies describe systemic risk as the risk of a disruption to financial services caused by an impairment of all or parts of the financial system, with serious negative consequences for the real economy.
The key features are:
- Interconnection: institutions hold each other's debt, act as each other's counterparty, or rely on the same central counterparty.
- Contagion: stress moves from one firm or market to others. See financial contagion.
- Procyclicality: falling prices force sales, and those sales push prices down further.
- Real-economy impact: lending stops and payments slow. See credit crunch.
Systemic risk example (hypothetical)
Bank A is a large lender. Many smaller banks have deposits with it, and several funds use its bonds as collateral.
- Bank A reports large loan losses and cannot roll over its short-term funding.
- Depositors withdraw at the same time, which is a bank run. Bank A then defaults.
- Smaller banks lose the deposits they held at Bank A. Funds face margin calls because the collateral has lost value.
- To raise cash, these firms sell bonds and shares. Prices fall across markets, including assets unrelated to Bank A.
- Banks stop lending to each other, and businesses lose access to credit.
What began as a problem at one firm becomes a problem for the whole system. The collapse of Lehman Brothers during the global financial crisis followed a similar path.
For a trader, events like this show up as sharp gaps, wider spreads, thin liquidity and sometimes circuit breakers. Leveraged CFD and forex positions can lose money very fast in these conditions. Stop-losses may be filled at worse prices, and margin can be wiped out before a stop-out level is reached.
Market risk types: where systemic risk fits
| Risk type | Meaning | Reduced by diversification? |
|---|---|---|
| Specific (idiosyncratic) | Affects one company or asset | Yes |
| Systematic (market risk) | Affects the whole market, for example rates or recessions; measured by beta | No |
| Systemic | Collapse or breakdown of the financial system itself | No |
| Currency risk | Losses from exchange rate moves | Partly |
Edge cases
- Systematic vs systemic: the two are often confused. Systematic risk is ordinary market-wide movement. Systemic risk is the system breaking down.
- Black swans: a black swan can trigger systemic risk, but many systemic crises build slowly through leverage. See fat tails.
- Policy responses: regulators label some institutions systemically important and apply tighter capital rules. Tools such as bail-in aim to stop losses spreading.
Where the term appears
- Central bank financial stability reports and regulators' speeches.
- News during banking stress, sovereign debt problems or a flash crash.
- Broker and fund risk disclosures, usually alongside counterparty and liquidity risk.
- Market commentary about flight to quality, when money moves into government bonds or gold.
Trading platforms do not show systemic risk as a number. You see its effects through spreads, gaps and margin levels. Practical controls are covered under risk management.
Frequent questions
What is systemic risk in simple words?
It is the risk that problems at one key firm or market spread until the whole financial system stops working normally.
Is systemic risk the same as systematic risk?
No. Systematic risk is market-wide price risk that diversification cannot remove. Systemic risk is the failure of the system itself.
Can diversification protect against systemic risk?
Mostly not. In a systemic crisis, correlations between assets tend to rise, so many assets fall together.
How does systemic risk affect retail traders?
It shows up as gaps, wider spreads, poor liquidity and margin calls. These can cause fast losses on leveraged positions.
Where can I find related terms?
See the trading glossary, including fractional reserve banking and clearing and settlement.