What is Systemic Risk? - Definition & Analysis

Instructor: Douglas Stockbridge

DJ Stockbridge is currently pursuing a Masters degree in Accounting.

In this lesson, we'll define systemic risk by first using an analogy of a group of people on a deserted island. We'll then give the formal definition for this type of risk and provide some examples.

The Renegade on the Deserted Island

Imagine you are trapped on a deserted island. You had been traveling on a cruise ship in the Pacific Ocean, but the ship must have hit something. All you remember is being violently thrown from the ship. The next memory you have is being covered in sand on the beach of this island. You quickly learn there are nine other people with you. They were on the same cruise ship.

Over the following weeks, you and the other survivors divvy up tasks. Everything is running as smoothly as it can, but then suddenly one of the other survivors gets an idea. This idea leads to a disagreement. The disagreement starts when he tries to make the land more fertile through 'controlled' fires. He starts a brush fire, and once the fire has died out he plants seeds in the scorched earth. Most of the group strongly disagree with this practice because they worry that the fires may get out of hand, especially because the island is so densely forested.

Nonetheless, the renegade keeps doing this and convinces two other people to join him on the other side of the island. In your previous life, you worked on Wall Street and this episode eerily reminds you of the Financial crisis. An individual looks out for their own self-interest and yet in the process they risk bringing the whole island civilization down with them. ''Yes,'' you think to yourself. ''Systemic risk here is very similar to systemic risk in the financial markets.''

In this lesson, we'll describe systemic risk, and we'll discuss how this type of risk played a large part in the financial crisis and continues to be on the minds of investors and regulators to this day.

Systemic Risk

Systemic risk is the risk of collapse of an entire financial system or market. This is in contrast to the risk of collapse of any individual entity, group or component of the system. The key to such a large-scale collapse are links between the entities. It's like a disease. Often the best way to stop its spread is to quarantine.

If infected parties mingle with others, then a cascading failure can ensue. This is when one failure in an interconnected system triggers the failure of other parts. Traffic is a good example of systemic risk with cascading failures. If there is one accident on a busy turnpike, then a large back-up can ensue. Drivers who know about the accident may decide to get off and use local roads, but if enough drivers think the same way then the local roads will get packed as well. One accident can spread until the entire transportation system is rendered temporarily useless.

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