In today’s rapidly evolving world, companies of all sizes and backgrounds face increasingly significant threats. Systemic risk, not to be confused with systematic risk, is just an example of a threat vector that can destroy not just a business, but an entire economy. 

In the complex financial system, systemic risk is one of the most significant concerns every institution, commercial bank, and financial services company must be aware of. The threat of systemic risk has inspired regulators to implement new strategies for protecting data and financial stability and has pushed endless organizations to rethink their security strategy.

Here’s what you need to know about the impact of systemic risk in today’s world. 

What is Systemic Risk? An Introduction

Systemic risk refers to the possibility that an event at a company level could potentially trigger a collapse of an entire banking sector or economy. Evaluators of systemic risk look at the potential for security issues or failure in a large bank to fundamentally harm an entire ecosystem.

The word “systemic” comes from the healthcare landscape, and is usually used to refer to a health issue that can affect a person’s entire body. The federal government often uses systemic risk in the financial market as a justification to intervene in the economy and prevent financial crises. 

For instance, systemic risk was considered a major contributor to the financial crisis of 2008. Most companies affected by systemic risks are called “too big to fail”. This doesn’t necessarily mean the company cannot fail, but that its failure would have a ripple effect on the wider market. 

The most important feature of systemic risk is that an internal risk in a bank or financial system can spread from unhealthy companies to healthier institutions. 

What is an Example of Systemic Risk?

Examples of systemic risk can stem from simple issues, like banking cybersecurity errors and major changes in the economy. One commonly referenced example of systemic risk comes from the Lehman Brothers, an investment banking company with a huge impact on the financial sector.

The size of the company and its integration with the US banking system and economy made it a huge source of systemic risk. When the firm collapsed, the entire financial market in the US was affected. Capital markets froze, and businesses and consumers struggled to access loans. 

Another example comes from AIG, a company that also faced serious financial problems, and was highly connected with other firms in the financial industry. The issues of the company led to a loss of liquidity, a downgrade in AIG’s credit rating, and collateral calls. 

Although the U.S. government didn’t provide support to Lehman, it did bail out AIG, with loans of more than $180 billion to prevent it from going bankrupt. 

How does systemic risk affect the global economy?

The impact of systemic risk on the financial markets, monetary policy of countries, and the economy overall has prompted the development of new regulations for risk management. The ripple effect caused by the failure of a large financial institution can potentially bring down an entire economy. 

This problem has grown more severe as consolidation in the banking landscape has led to the creation of extremely large firms. The 2008 global crisis prompted financial regulator industries to begin focusing on finding ways to make the banking system less vulnerable to shocks. 

Firewalls were created by financial regulation teams to prevent damage from systemic risk. Additionally, regulators began to create microeconomic and macroeconomic policies, with an increased emphasis on macroprudential policy. 

Today, macroprudential regulation seeks to safeguard the financial system and banks on a massive scale, while micro-prudential regulation looks at the regulation of specific individual firms. 

Can Systemic Risk Be Avoided?

The development of new policies and regulations on a global scale aims to address the rising concern of systemic risk on a certain level. The Federal Reserve System and Federal Reserve Bank are providing new guidance to business leaders for risk management. 

At the same time, systemic risk technology and innovation are increasing, paving the way for more comprehensive disaster risk reduction plans. 

However, in a world where many market participants are still struggling to find the best ways to address their cybersecurity risks, many struggle with systemic risk protection. Systemic risk is harder to fight against, as it’s much more difficult to detect.

Additionally, threats are becoming harder to control now that the data center climate is becoming more of a global mesh, spread across different SaaS platforms. 

Addressing systemic risk in the financial system requires an approach that’s different from the perimeter-focused strategies many companies used in the past. Organizations now need to think more holistically about how they can mitigate risks on a holistic level with the right policy measures and controls. This requires a multi-layered approach to risk management. 

What is the greatest defense against systemic risk?

Various banking supervision groups have begun creating strategies and guidelines for minimizing systemic and climate risks on a wider scale. For instance, the Basal Committee created a reform package designed to improve the banking sector’s ability to absorb and reduce economic and financial stress shocks, with access to better capital and liquidity. 

At the same time, leaders in the industry recommend taking steps which include:

  • Creating a comprehensive resolution and enterprise risk management regime, with step-by-step strategies for dealing with systemic risk when issues occur. 
  • Adjusting the structure of the financial industry, by adopting measures to avoid perverse incentives that spur leverage and the growth of short-term profit. 
  • Creating a more robust market infrastructure, with robust central counterparties and transaction channeling methods to reduce financial contagion. 
  • Implementing a proactive strategy to tax bigger, more interconnected companies, to prevent the damage caused by insolvency. 
  • Improved supervision from the central bank and financial stability board, to help pinpoint issues and moral hazard concerns before they emerge. 

How can RiskRecon, a Mastercard Company, Help Me?

Tackling systemic risk is a complex process requiring a comprehensive end-to-end risk prevention and reduction strategy. However, implementing a careful assessment and visibility strategy is one of the most important steps in preventing and reducing systemic risk. 

Our systematic risk assessment offers access to a comprehensive systemic risk assessment solution powered by Interos. The solution provides a full ecosystem view of relationship risk, illuminating a company’s entire network of business relationships. 

With the help of RiskRecon, companies can proactively monitor and assess evolving business risks across multiple dimensions and throughout their entire network of business relationships. Discover how we can help you overcome the challenges of systemic risk, with a demo of our world-class systematic risk assessment software.