Systemic risk

In finance, systemic risk describes the likelihood of the collapse of a financial system, such as a general stock market crash or a joint breakdown of the banking system. As such, it is a type of "aggregate risk" as opposed to "idiosyncratic risk", which is specific to individual stocks or banks. Systemic risk should also be carefully distinguished from Non-systemic risk, which describes risks which the whole economy faces such as business cycles or wars.

In banking, banks hold capital to absorb credit risk (e.g. bad loans), market risk (e.g. interest rate risk) and operational risk (e.g. exposure to lawsuits). In recent years development of international derivative markets led to tendencies of banks to sell their credit risk through "credit risk derivatives", a trend that has become popular under the heading of "securitization".

In insurance it is difficult to obtain financial protection against "systemic risks" because of the inability of any counter-party to accept the risk. For example it is difficult to obtain insurance for life or property in the event of nuclear war. The essence of systematic risk is therefore the correlation of losses. "Systemic Risk" adds the important problem, that it is much more difficult to evaluate than "systematic risk". For example, while econometric estimates and expectation proxies in business cycle research led to a considerable improvement in forecasting recessions, data on "Systemic Risk" is often hard to obtain, since interdependencies and counter party risk on financial markets play a crucial role. If one bank goes bankrupt and sells all its assets, the drop in asset prices may induce liquidity problems of other banks, leading to a general banking panic.

One concern is the potential fragility of some financial markets. If the participants are trading at levels far above their capital bases, then the failure of one participant to settle trades may deprive others of liquidity, and through a domino effect expose the whole market to systemic risk.

Diversification
Risks can be reduced in four main ways: Avoidance, Reduction, Retention and Transfer. Systematic risk is a risk of security that cannot be reduced through diversification. Also sometimes called market risk or un-diversifiable risk. Participants in the market, like hedge funds, can themselves be the source of an increase in systemic risk and transfer of risk to them may, paradoxically, increase the exposure to systemic risk.

Regulation
One of the main reasons for regulation in the marketplace is to reduce systemic risk.