Systemic risk is the vulnerability to unpredicted events including major catastrophes and earthquakes among others. These events affect the distribution of resources and the amount of resources in the market.
Systemic risk can also be defined as risk inherent to the entire market segment. It usually affects the overall market and not only the industry and stocks. Undiversifiable risk, market risk or volatility risk is caused by events that cannot be avoided completely. What’s more, it cannot be mitigated through diversification but only through the use of the right asset allocation strategy.
Putting assets in bonds and assets in stocks can easily mitigate a systemic risk. This is based on the fact that interest rates often shift and makes bonds less valuable to make stocks more valuable and vice versa. As a result, it limits the overall change in the portfolio value from systematic changes.
Interest rate changes, recessions, wars and inflation can also cause systemic risk. These factors affect the entire market. Systemic risk is one of the risks that underlie all other market and investment risks across the globe.
The Great Recession is one of the best examples of systemic risk. It is a risk that affected many businesses across the globe. Any person who had invested in the market in 2008 suffered a great loss. The value of many investments changed because of the Great Recession. It was a market wide economic event that affected investments regardless of the type of securities that one had held.
The Great Recession also affected different asset classes in different ways. Even so, investors with broader allocations were affected less than those with stocks only. To understand how much systemic risk a portfolio, fund or security has, it is always essential to take a closer look at its beta. This helps you to measure how volatile an investment is in the market compared to others.
A beta that is more than 1 means that a fund is more volatile in the overall market and less than one means that a fund has a less systemic risk. If a beta is equal to one, this means that a fund has the same systemic risk as the market itself.
The federal government often uses systemic risk as a clear justification for it to intervene in the economy. The main basis for intervention by Fed is to ensure the ripple effect from a company level in any event through targeted regulations is reduced. For instance, Dodd-Frank Act of 2010 was put in place with an enormous set of new laws aimed at preventing another event of the Great Recession from occurring. The laws regulate financial institutions and firms by limiting systemic risk.
According to researchers and economists, the size of Lehman Brother’s size and its integration in the US market or economy has made it a great source of systemic risk, when the firm collapsed; the US witnessed a lot of problems in the country’s economy as well as the financial system. Additionally, capital markets froze up, consumers could not access any loans and businesses could only get loans only if they were creditworthy. Those that posed minimal risks to the lender could also access loans.
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