Definition
Systemic risk is the risk that the failure of one financial institution, market, or instrument can propagate through the network of financial relationships to threaten the stability of the entire financial system — and through it, the real economy. It is the risk of crisis as a system property, not a property of any single firm. Unlike idiosyncratic risk (which any one firm bears alone), systemic risk is what links firms together and what makes the collapse of one capable of bringing down many.
It arises from three reinforcing features of modern finance: interconnectedness (banks lend to each other and hold each other's debt), leverage (small losses on assets translate into large losses on equity), and common exposures (many institutions hold the same kind of asset and face the same shocks). Each amplifies the others.
Why it matters
How it works
Systemic risk manifests in three main forms. Domino effects: institution A fails, causing losses at B and C, which fail, causing losses at D, E, F. Common shock: many institutions hold the same asset class; when that class loses value, they all lose at once. Fire sales: institutions facing losses must sell assets to meet capital requirements; the simultaneous selling pushes prices down further, deepening losses, forcing more selling.
Modern finance is structured to facilitate these dynamics. Securitisation spread mortgage risk across many institutions, making the failure of any one less probable but the simultaneous failure of many more likely. Derivatives concentrate counterparty risk in a few large dealers, whose failure would propagate through the entire derivatives book. Money-market funds, supposedly safe, can experience runs that freeze short-term funding for the whole system — as happened in September 2008.