Systemic risk is the risk that a company-level event could destabilize an entire industry. Think back to the financial crisis of 2008, when many companies deemed “too big to fail” did exactly that. To safeguard your investments for the next market adjustment, it helps to understand the factors that contribute to a downturn. Read on to learn more about systemic risk and how it can impact your future financial security.
Systemic Risk, Explained
Systemic risk can also be defined as a risk imposed by interconnected organizations where the failure of one organization within a system or market can cause a ripple effect. This ripple effect can then push the entire system or market into bankruptcy or collapse.
Companies and groups of organizations that carry systemic risk make up a big portion of their industries and a significant part of the economy. Because these companies play a big role in how the economy functions, the U.S. government often intervenes. By enforcing regulations, the federal government can reduce the impact of a company-level event.
However, there are times when the federal government will stand on the sidelines and not intervene with a large company. They may do this because the economy has grown and they want to give it time to adjust.
Systemic Risk vs. Systematic Risk
Often confused with systemic risk, systematic risk has a more general meaning. Also known as market risk, systematic risk means the potential volatility that lies within the overall market. Recessions, a weak economy, wars, and rising or stagnant inflation rates are often the cause of systematic risk. This type of risk is not avoidable, but there are ways you can manage it.
To reduce your risk exposure (and maximize your returns), investors should diversify their portfolios by investing in an array of asset classes, such as domestic and international stocks, bonds, real estate and short-term cash investments. Since each asset class will react differently in various market conditions, diversifying reduces the overall volatility of your portfolio.
Systemic Risk in Action
One example of systemic risk many investors are familiar with is the collapse of Lehman Brothers in 2008. Due to the firm’s size and connection to the U.S. economy, its collapse sent a cascading effect through the financial system and the economy as a whole. When consumers and organizations could no longer receive loans, markets were at a standstill.
The insurer AIG was also struggling financially, through its portfolio connection with subprime mortgages and involvement in residential mortgage-backed securities. But luckily for AIG, the federal government came to their rescue. Unlike Lehman Brothers, the government bailed out AIG with $182 billion in loans. The effort helped them avoid bankruptcy and prevent the collapse of other intertwined companies.
Regulations Put in Place
To monitor the threat of systemic failure, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 created several new agencies to protect consumers and regulate the financial industry. The Financial Services Oversight Council (FSOC), for example, is charged with identifying risks and responding to emerging threats to the nation’s financial system. The FSOC also has the authority to subject non-bank institutions that pose systemic risk to strict oversight and supervision.
Dodd-Frank authorizes the FDIC to guarantee the assets and liabilities of firms that may fail. It also requests lists of firms that may need special oversight from the Federal Reserve. Established by Congress in 1933, the FDIC is responsible for stability and public confidence by insuring banking deposits, supervising financial firms and providing consumer protection.
The Bottom Line
While the federal government is working to protect investors from systemic risk, it’s still important to understand how it impacts the market. Whether you’re an amateur or experienced investor, educating yourself on investing terminology can help you better understand your investment strategy and the potential risks.
Tips for Investors
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