Systemic Risk in Banking

Systemic risk is the risk that trouble in one bank, several banks, or a financial market disrupts the wider financial system and harms the economy. Unlike the failure of an individual institution, it threatens essential financial services such as payments, deposit withdrawals and credit supply. It can arise through contagion between institutions or through a common shock affecting many banks simultaneously.

How banking failures spread

Banks connect depositors, borrowers, other banks and financial markets. These connections allow a problem originating in one institution to spread through several channels.

• Interbank exposures transmit losses when a failing bank cannot repay funds owed to other financial institutions.
• A bank run occurs when many depositors seek withdrawals together; fear about one bank can also undermine confidence in otherwise sound banks.
• Fire sales occur when distressed banks sell assets urgently, depressing prices and potentially causing losses for other institutions holding similar assets.
• Disruption at an important bank can interrupt payments and settlements, affecting institutions and businesses that depend on its services.

When an individual failure becomes systemic

Not every bank failure creates a banking crisis. Its systemic impact depends on the institution's connections and functions, the condition of other banks, and the effectiveness of safeguards.

• Size, interconnectedness and lack of substitutes can make a bank's failure especially disruptive because other institutions cannot easily replace its services.
• Common exposures, such as heavy lending to the same sector, can cause several banks to suffer losses together even without direct contagion.
• A liquidity problem means a bank cannot meet immediate payment demands; a solvency problem means its assets are insufficient to cover its liabilities.
• Banks responding to losses by restricting lending can weaken investment, production and employment; worsening borrower finances can then create further banking losses.

How systemic risk is contained

Containing systemic risk requires both sound individual banks and oversight of risks across the financial system.

• Capital and liquidity requirements strengthen banks' capacity to absorb losses and meet withdrawals.
• Macroprudential oversight examines system-wide vulnerabilities, including interconnectedness, concentrated exposures and excessive credit growth.
• Deposit insurance and central-bank liquidity support help protect confidence, while effective resolution arrangements seek to manage failing banks without disrupting critical services.
• The Reserve Bank of India identifies domestic systemically important banks and subjects them to additional capital requirements because their distress could have wider consequences.