The Pervasive Threat of Systemic Risk
Systemic risk represents the potential of an event at the corporate level triggering severe instability, or even the collapse of an entire industry or economy. This type of risk was a significant contributor to the financial crisis of 2008. Companies involved in systemic risk are often labeled as “too big to fail.” These large and interconnected institutions play critical roles in their respective industries or the broader economy, marking them as sources of systemic risk. It’s important to note that systemic risk differs from systematic risk, which pertains to the entire financial system.
Comprehending Systemic Risk
Systemic risk frequently serves as a rationale for federal government intervention in the economy. The belief driving this is that the government can minimize the ripple effects of a company-level event through strategic regulations and actions. While some firms are seen as too crucial to fail, without governmental intervention, they stand a real chance of collapsing during economic turbulence. Occasionally, however, the government might opt not to intervene to allow the overheated market to stabilize. Generally, this is rare as it can hurt the economy more than expected due to consumer sentiment impacts.
Real-World Influences of Systemic Risk
Proactive Measures: The Dodd-Frank Act
The Dodd-Frank Act of 2010, officially the Dodd-Frank Wall Street Reform and Consumer Protection Act, was established to prevent a recurrence of the Great Recession by imposing strict regulations on key financial institutions. There is ongoing debate about modifying these reforms to promote small business growth.
The Lehman Brothers Collapse
Lehman Brothers’ systemic risk stemmed from its size and integration within the U.S. economy. When Lehman collapsed, it triggered widespread instability, freezing capital markets and severely constricting business and consumer loans to those of the highest creditworthiness.
The AIG Crisis
Similarly, AIG faced significant financial troubles during the crisis. Its extensive portfolio of subprime mortgages and residential mortgage-backed securities instigated liquidity issues and credit downgrades. Unlike Lehman, AIG received an extensive government bailout exceeding $180 billion, preventing its bankruptcy, which analysts believed could have led to the collapse of numerous other financial institutions.
Engaging with these examples highlights the importance of understanding systemic risk and underscores the necessity for well-structured economic regulations to mitigate such risks effectively.
Related Terms: Financial crisis, Too big to fail, Systematic risk, Dodd-Frank Act, Financial institutions.
References
- Congressional Research Service. “Financial Regulation: Systemic Risk”, Pages 1-2.
- Commodity Futures Trading Commission. “Dodd-Frank Act”.
- Congressional Research Service. “Financial Regulation: Systemic Risk”, Page 3.
- Federal Reserve Bank of New York. “Actions Related to AIG”.
- Congressional Research Service. “Financial Regulation: Systemic Risk”, Page 9.
- U.S. Department of the Treasury. “AIG Program Status”.
