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What is Systemic Risk in Finance?
The risk that occurs due to the system of economy is known as systematic risk. Systematic risk is complex in nature and is beyond the control of an individual or a specific company. In general, all investments and securities are prone to such kinds of risk.
Systemic risk includes unforeseen events that happen automatically, making it uncontrollable and beyond the will of a single person or company. Systemic risk usually impacts the entire industry rather than a single company or security.
Note − Systemic risks cannot be avoided by diversification.
Example #1: The 1866 Overend and Gurney Collapse
Overend and Gurney was a brokerage firm based in London. In 1802 it ventured into high-risk lending, with a particular concentration on the shipping industry. The outcome of such focus was negative, which forced the firm into bankruptcy with the refusal of its bailout pleas by the then Bank of England.
The impacts of this collapse did not have a ripple effect, but panic spread very fast through the entire financial system. Liquidity from the market vanished, and even the relatively safe assets’ liquidity dried up.
The result was a severe recession in the British Economy.
Example 2: Lehman Brothers
The Systemic risk belonged to the Bankruptcy of Lehman Brothers Holdings Inc., a large financial services firm based in the US. Founded in 1847, Lehman Brothers Holdings Inc. had the global financial market under its belt. It was the 4th largest financial service worldwide. The 158-year operational supremacy, however, was over in 2008.
The result − The contribution of the firm to the U.S. economy was large, so the bankruptcy meant that the crash cascaded into a catastrophe in the entire financial system, making the capital market stagnant and causing difficulties for getting loans by firms and individuals.
Example 3: Bankruptcy of AIG
The next example of systemic risk is the bankruptcy of the global finance and insurance provider American International Group (AIG). AIG has had operations in over 80 countries and jurisdictions. During the 2008 financial crisis prompted by Lehman Bros, the Federal Reserve bailed out AIG for a stimulus of $180 million. AIG’s problems occurred due to mass sales and unhedged general insurance.
AIG did not go bankrupt in contrast to Overend and Gurney and Lehman Brothers Holdings Inc due to the government bailout. The main reason for the bailout was that its collapse would have meant the end of many other financial firms. With AIG, government intervention pulled the company up from sureshot danger. It was an essential mediation, as AIG’s crash would have triggered a severe economic downturn.
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