Systemic Risk

Systemic risk is the risk that disruption in part of the financial system spreads or intensifies enough to impair the system’s ability to provide essential financial services. It concerns widespread disruption to credit, payments or other financial services that can seriously harm the real economy, rather than losses confined to one institution or investor.

How interconnectedness spreads distress

Financial institutions are connected through lending, payment arrangements, common investments and confidence. These connections normally support financial activity, but they can also transmit and amplify shocks.

• Contagion occurs when distress at one institution spreads to others, for example when its failure to repay interbank borrowing causes losses for creditor banks.
• Institutions holding similar assets can suffer simultaneous losses; forced sales can depress prices further, creating a fire-sale spiral.
• A loss of confidence can trigger withdrawals or refusal to renew short-term funding, forcing otherwise viable institutions to sell assets or curtail lending.
• Disruption at an important payment or settlement institution can obstruct transactions across the wider financial system.

What makes a financial system vulnerable

Systemic risk depends on both the structure of financial connections and the build-up of vulnerabilities over time. It can arise from one institution’s failure or from a common shock affecting many institutions together.

• High leverage magnifies losses because a relatively small fall in asset values can substantially erode an institution’s capital.
• Maturity mismatch, such as financing long-term loans with short-term funds, creates vulnerability when funding cannot be renewed.
• Concentrated lending and common exposures make institutions vulnerable to the same borrower, sector or asset-price shock.
• Rapid credit growth and rising asset prices can reinforce each other during a boom; their reversal can generate losses and a contraction in credit.

Why system-wide safeguards are needed

Microprudential regulation focuses on the soundness of individual institutions, while macroprudential policy addresses risks to the financial system as a whole. Individually prudent actions, such as selling assets during stress, can collectively worsen instability.

• Capital and liquidity requirements strengthen institutions’ capacity to absorb losses and withstand funding stress.
• System-wide stress tests and monitoring of interconnected exposures help authorities assess vulnerabilities under adverse conditions.
• Countercyclical capital buffers can build resilience during excessive credit growth and provide room to absorb losses during stress.
• Credible resolution arrangements and central-bank liquidity support can help contain disruption, while safeguards are needed to limit incentives for excessive risk-taking.