What is Systemic Risk?

systemic riskSystemic risk is the possibility that an event at the company level could trigger severe instability or collapse an entire industry or economy. Systemic risk was a major contributor to the financial crisis of 2008. Companies considered to be a systemic risk are called too big to fail.

In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system, that can be contained therein without harming the entire system

Systematic risk is the risk inherent to the entire market or market segment. Systematic risk, also known as undiversifiable risk, volatility or market risk, affects the overall market, not just a particular stock or industry. This type of risk is both unpredictable and impossible to completely avoid. It cannot be mitigated through diversification, only through hedging or by using the correct asset allocation strategy.

Systematic risk underlies other investment risks, such as industry risk. If an investor has placed too much emphasis on cybersecurity stocks, for example, it is possible to diversify by investing in a range of stocks in other sectors, such as healthcare and infrastructure. Systematic risk, however, incorporates interest rate changes, inflation, recessions and wars, among other major changes. Shifts in these domains can affect the entire market and cannot be mitigated by changing around positions within a portfolio of public equities.

To help manage systematic risk, investors should ensure that their portfolios include a variety of asset classes, such as fixed income, cash and real estate, each of which will react differently in the event of a major systemic change. An increase in interest rates, for example, will make some new-issue bonds more valuable, while causing some company stocks to decrease in price as investors perceive executive teams to be cutting back on spending. In the event of an interest rate rise, ensuring that a portfolio incorporates ample income-generating securities will mitigate the loss of value in some equities.

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.

If you want to know how much systematic risk a particular security, fund or portfolio has, you can look at its beta, which measures how volatile that investment is compared to the overall market. A beta of greater than 1 means the investment has more systematic risk than the market, while less than 1 means less systematic risk than the market. A beta equal to one means the investment carries the same systematic risk as the market.

Regulation

One of the main reasons for regulation in the marketplace is to reduce systemic risk. However, regulation arbitrage – the transfer of commerce from a regulated sector to a less regulated or unregulated sector – brings markets a full circle and restores systemic risk. For example, the banking sector was brought under regulations in order to reduce systemic risks. Since the banks themselves could not give credit where the risk (and therefore returns) were high, it was primarily the insurance sector which took over such deals. Thus the systemic risk migrated from one sector to another and proves that regulation of only one industry cannot be the sole protection against systemic risks.

The opposite of systematic risk, unsystematic risk, affects a very specific group of securities or an individual security. Unsystematic risk can be mitigated through diversification.

 


 

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