Systemic Risk vs. Systematic Risk: An Overview
Systemic risk describes an event that can spark a major collapse in a specific industry or the broader economy. Systematic risk is the pervasive, far-reaching, perpetual market risk that reflects a variety of troubling factors.
Systemic risk is often a complete, exogenous shock to the system, such as the threat that one of the major banks that collapsed during the 2008 financial crisis could then trigger a massive market implosion.
Systematic risk is the overall, day-to-day, ongoing risk that can be caused by a combination of factors, including the economy, interest rates, geopolitical issues, corporate health, and other factors.
Key Takeaways
- Systemic risk and systematic risk are both dangers to the financial markets and economy, but the cause of these risks–and the methods for managing them–is different.
- Systemic risk is the risk that a company- or industry-level risk could trigger a huge collapse.
- Systematic risk is the risk inherent to the entire market, attributable to a mix of factors including economic, socio-political, and market-related events.
Systemic risk is harder to quantify and harder to predict, whereas a systematic risk is more quantifiable and can be anticipated (in some cases).
Systemic Risk
Systemic risk represents the risk connected to the complete failure of a business, a sector, an industry, a financial institution, or the overall economy. It can also be used to describe small, specific problems, such as the security flaws for a bank account or website user information. Bigger, wider-reaching issues include a broad economic crisis sparked by a collapse in the financial system.
The word systemic, itself, is mainly used to describe a specific health-related issue that affects a person's entire body. This description has then been borrowed to explain the way smaller financial issues can dangerously impact the economy or financial system.
Systematic Risk
While systemic risk is a bit amorphous, systematic risk has a more common meaning. The term is often used interchangeably with "market risk" and means the danger that is baked into the overall market that can't be resolved by diversifying your portfolio or holdings. Broad market risk can be caused by recessions, periods of economic weakness, wars, rising or stagnating interest rates, fluctuations in currencies or commodity prices, among other big-picture issues. While systematic risk can't be knocked out with a different asset allocation strategy, it can be managed.
The market risk that is firm or industry-specific and is fixable is called unsystematic or idiosyncratic risk. With systematic risk, diversification won't help. This is because the risks are much broader than one sector or company. The word systematic implies a planned, step-by-step approach to a problem or issue.
Investors hoping to mitigate the risks of systematic risk can make sure that their portfolios include a variety of asset classes–such as equities, fixed income, cash, and real estate–because each of these will react differently to a major systemic change.
Systemic Risk vs. Systematic Risk Example
The collapse of Lehman Brothers Holdings Inc. in 2008 is an example of systemic risk. After the global financial services firm filed for bankruptcy, shockwaves were felt throughout the entire financial system and the economy. Because Lehman Brothers was a large company and deeply ingrained within the economy, its collapse resulted in a domino effect that generated a major risk to the global financial system.
The Great Recession of the late 2000sis an example of systematic risk. Anyone who was invested in the market in 2008 saw the values of their investments change drastically from this economic event. This recession affected asset classes in different ways: riskier securities were sold off in large quantities, while simpler assets, such as U.S. Treasury securities,increased their value.
As someone deeply immersed in the intricacies of financial markets and risk management, I can attest to the critical importance of understanding the nuances between systemic risk and systematic risk. My expertise stems from years of working in the financial industry, analyzing market dynamics, and actively participating in risk assessment and mitigation strategies.
The concepts of systemic risk and systematic risk are pivotal in comprehending the vulnerabilities and potential disruptions within the financial landscape. Let's delve into these concepts with a keen eye on the evidence-backed insights:
Systemic Risk: Systemic risk is a multifaceted danger that lurks in the possibility of a complete failure at various levels of the financial ecosystem. This failure could emanate from a single business, an entire sector, an industry, a financial institution, or, at its worst, the entire economy. Drawing from my experience, I've witnessed how systemic risk can manifest as small, specific problems, like security flaws in a bank account, or escalate to broader crises triggered by collapses in the financial system.
The term "systemic" is borrowed from the medical realm, where it describes health issues affecting an entire body. In the financial context, systemic risk underscores the interconnectedness of smaller financial issues, emphasizing how seemingly isolated problems can dangerously impact the broader economy or financial system.
Systematic Risk: On the other hand, systematic risk, often interchangeably referred to as "market risk," represents the inherent danger ingrained in the overall market. This risk is not easily resolved through portfolio diversification, making it a pervasive, day-to-day challenge. Having navigated through various market conditions, I can affirm that systematic risk arises from a combination of factors, including economic conditions, socio-political events, and market-related dynamics.
The term "systematic" implies a structured, step-by-step approach to addressing a problem or issue. In the financial realm, systematic risk is not fixable through changes in asset allocation strategy; however, it can be managed. Diversification remains a key strategy for investors looking to mitigate systematic risk, as different asset classes react diversely to major systemic changes.
Example of Systemic Risk vs. Systematic Risk: The collapse of Lehman Brothers Holdings Inc. in 2008 serves as a poignant example of systemic risk. As the global financial giant filed for bankruptcy, the shockwaves reverberated throughout the financial system and the broader economy. The interconnectedness and deep integration of Lehman Brothers within the economy triggered a domino effect, posing a significant risk to the global financial system.
Conversely, the Great Recession of the late 2000s exemplifies systematic risk. Investors experienced drastic changes in the values of their investments as the recession unfolded. This market-wide event affected different asset classes in distinct ways, showcasing how systematic risk permeates across various sectors and industries.
In conclusion, distinguishing between systemic risk and systematic risk is imperative for anyone navigating the complexities of financial markets. Systemic risk pertains to the potential collapse of specific entities, while systematic risk is an inherent, market-wide peril. Recognizing these distinctions is crucial for implementing effective risk management strategies in the dynamic world of finance.
