What is systemic risk?

Systemic risk refers to the potential for the failure of one financial institution to trigger a chain reaction that results in the collapse of an entire financial system or market. This concept highlights how interconnected financial institutions are; a significant disruption in one area can propagate through the system due to these linkages. In this way, systemic risk is crucial for understanding financial stability, as it emphasizes that the health of the financial system relies not only on the soundness of individual banks or institutions but also on their interrelationships and the overall structure of the financial system.

For instance, if a major bank were to fail, it could lead to losses for other banks, a contraction in credit availability, and a loss of confidence in the entire banking sector. This phenomenon can result in severe economic repercussions beyond just the initial bank's failure, illustrating the broader implications of systemic risk. Understanding this concept is crucial in the fields of economics and finance, particularly regarding regulatory frameworks designed to mitigate such risks.