Systemic Risk

What Is Systemic Risk?

Systemic risk is the danger that trouble at one financial institution or in one market could cascade into failures across the entire financial system, rather than staying contained. Because banks, insurers, and funds are linked through lending, contracts, and shared exposures, the collapse of a large, interconnected firm can inflict losses on many others and freeze the flow of credit that the broader economy depends on. This interconnectedness is why some institutions are described as too big to fail. The concern that one major failure could bring down the whole system was central to decisions made during the 2008 financial crisis.

Why It Matters

Systemic risk matters because it justifies extraordinary interventions that would be hard to defend for a single failing firm. Fears that AIG's collapse would ripple through the institutions relying on its guarantees drove its rescue, while the decision to let Lehman Brothers fail in September 2008 is still debated as a factor that intensified the crisis. To monitor such dangers, the 2010 Dodd-Frank Act created the Financial Stability Oversight Council to watch risks across the whole system. Commentators again invoked systemic risk during the 2020 COVID-19 crash. The concept explains why regulators focus not just on individual firms but on the connections among them.

Test Your Knowledge

Questions on this topic from the EconRecall fact bank:

• The concern that the failure of one major financial institution could cascade into failures across the broader financial system is best described by what term?
  Systemic risk
• What new oversight body did the Dodd-Frank Act establish to monitor systemic risk across the entire financial system?
  The Financial Stability Oversight Council (FSOC)
• Economists and commentators widely invoked what terms to describe the unprecedented, largely unforeseen nature of the pandemic-driven economic shock?
  "Systemic risk" and "black swan event"