🚩 How to Best Understand Systemic Risk in the Financial System
With several large bank failures in recent months, we are all reminded of the 2008 Great Financial Crisis and Recession, when millions lost their jobs, homes, and ways of life. While many factors contributed to this economic disaster, one term can cover nearly all of them: systemic risk. The financial system plays a crucial role in the global economy, facilitating the flow of funds, managing risk, and supporting economic growth. However, it is also vulnerable to systemic risk, which can have far-reaching consequences for the stability of financial markets and the broader economy. Let's look at what systemic risk is and how it can impact your behavior as an investor.
What is Systemic Risk?
According to the CFA Institute, systemic risk is "the risk of a breakdown of an entire system rather than simply the failure of individual parts." This could mean a lot of different things, but in finance, it refers to the risk of a cascading failure in the financial sector.1 Unlike idiosyncratic risk, which affects individual institutions or markets, systemic risk is characterized by its ability to spread across the entire financial system, often leading to a domino effect of failures.
There are several causes of systemic risk in the financial system. One key factor is interconnectedness, which refers to the interdependencies and linkages between financial institutions and markets. When institutions are highly interconnected, a failure or distress in one institution can quickly spread to others.
Another factor contributing to systemic risk is concentration. When a few large institutions hold significant market share or have dominant positions in key markets, their failure can disproportionately impact the financial system. This concentration of power can lead to a lack of diversification and increase the system's vulnerability to shocks.
Further, pro-cyclical behavior, which refers to the tendency of market participants to exacerbate market movements, can amplify systemic risk. For example, during an economic expansion, market participants may take on excessive risk, leading to the buildup of vulnerabilities in the financial system. However, these vulnerabilities can unravel rapidly when the economy turns, leading to a systemic crisis.
Every financial system has some level of systemic risk, and the consequences can be severe and far-reaching. So, policymakers seek to limit this risk by closely monitoring markets, analyzing global trends, and creating reforms to help protect the financial system and the economy as a whole.
For example, the Obama Administration signed the Dodd–Frank Wall Street Reform and Consumer Protection Act into law in July 2010 to respond to the 2008 financial crisis. The idea behind this legislation was to make the US financial system safer for consumers and taxpayers by establishing new government agencies to oversee our financial system. While it's impossible to limit all systemic risk, there are steps that the government and consumers can take to prevent something like the 2008 financial crisis from happening again.2
Regulators and policymakers employ various strategies to mitigate systemic risk in the financial system. One fundamental approach is through prudential regulation, which involves setting standards and requirements for financial institutions, such as capital adequacy, risk management, and liquidity. Another strategy is using macroprudential policies, which aim to address systemic risks that may arise from the behavior of the financial system as a whole. These policies can include countercyclical capital buffers, which require banks to build up capital during an economic expansion, and limits on loan-to-value mortgage ratios, which can prevent excessive borrowing during a housing boom.
How Systemic Risk Impacts Investors
While individual investors can't completely protect themselves from systemic risk, the concept teaches us many important lessons about investing and risk tolerance. For example, you can analyze current macroeconomic trends and research investment ideas to further diversify your portfolio and hedge against potential risks.
Systemic risk and market risk aren't equivalent, but they do raise the question, "How much risk is too much?" The answer to this question depends on your own personal risk tolerance. However, we can use systemic risk as motivation to take action in aligning your portfolio strategy with your risk profile. At Faubion Wealth, we utilize a quantitative risk management process to measure one's risk profile, which allows us to dial in a portfolio strategy tailored to who you are as an investor, giving you confidence in investing through any systemic risk event.
Looking at systemic risk also makes us more skeptical of companies that are "too big to fail." For example, Lehman Brothers' "size and integration" into the US economy made it a source of systemic risk. When the firm collapsed, it "created problems throughout the financial system and the economy."3 This risky "too big to fail" ideology is one of the reasons why the financial crisis of 2008 happened, and we appear to be going through a similar period of too big to fail with three bank bail-outs since March. All of these FDIC takeovers and bank deposit guarantees have been made using the systemic risk exemption, essentially saying they were too big to let fail. However, these policy decisions have been piecemeal and taken on one at a time, and there is no blanket guarantee that any future failing institutions will receive the same treatment. As a result, it's dangerous to blindly trust any company, big or small, without doing the proper research.
As an investor, it's essential to understand our economy as a whole and how things like systemic risk impact our daily lives and portfolio strategies. Today, like the 2008 financial crisis, should be a wake-up call for Americans, politicians, and investors to recognize how things can go wrong without the proper checks and balances. Understanding systemic risk is a good start for investors to understand the potential impact on their life's savings. And with a proper risk management process, ongoing diligent portfolio oversight, and macro-awareness, we can begin to protect ourselves from systemic risk.
Matt Faubion, CFP®
Founder - Wealth Manager
This content is developed from sources believed to be providing accurate information, and provided by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.