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Understanding Systemic Risk in Finance

Systemic risk refers to risks that cannot be diversified away and affect the entire market or economy. It stems from movements in the overall economy rather than issues specific to individual assets. While all assets are impacted by systemic risks like recessions, different industries are affected to varying degrees. Insurance also generally does not cover systemic risks since no party can take on risks that affect the entire market or economy, like those from nuclear war. Regulators aim to reduce systemic risk through financial industry oversight.

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25 views2 pages

Understanding Systemic Risk in Finance

Systemic risk refers to risks that cannot be diversified away and affect the entire market or economy. It stems from movements in the overall economy rather than issues specific to individual assets. While all assets are impacted by systemic risks like recessions, different industries are affected to varying degrees. Insurance also generally does not cover systemic risks since no party can take on risks that affect the entire market or economy, like those from nuclear war. Regulators aim to reduce systemic risk through financial industry oversight.

Uploaded by

mahantesh123
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© Attribution Non-Commercial (BY-NC)
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Systemic risk

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challenged and removed. (July 2007)
[dubious – discuss]

Systemic risk is a specific term used in finance, it means the market


risk or the risk that cannot be diversified away, as opposed to
"idiosyncratic risk", which is specific to individual stocks. It refers to the
movements of the whole economy. Even if we have a perfectly
diversified portfolio there is some risk that we cannot avoid and this is
the systemic risk. However, the systemic risk is not the same for all
securities or portfolios. Different companies respond differently to a
recession or a booming economy. For example, think of the automobile
industry compared to the food industry in case of a recession. Both of
them will be affected negatively but food industry not as much as
automobile industry.
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 systemic risk is
therefore the correlation of losses. "Systemic Risk" adds the important
problem that it is much more difficult to evaluate than "specific 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.[1]
Contents
[hide]

• 1 Diversification
• 2 Regulation
• 3 Project Risks
• 4 References

• 5 See also

[edit] Diversification
Risks can be reduced in four main ways: Avoidance, Reduction,
Retention and Transfer. Systemic 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[2] and transfer
of risk to them may, paradoxically, increase the exposure to systemic
risk.

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

[edit] Project Risks


In the fields of project management and cost engineering, systemic
risks include those risks that are not unique to a particular project and
are not readily manageable by a project team at a given point in time.
These risks may be driven by the nature of a company's project system
(e.g., funding projects before the scope is defined), capabilities, or
culture. They may also be driven by the level of technology in a project
or the complexity of a project's scope or execution strategy.[3]

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