What is systemic risk? Why is it so dangerous?

You can imagine the entire financial system as an incredibly complex Jenga tower built with blocks.

What is the meaning of "systemic risk"?

When playing Jenga, if you pull out one block, the tower usually won't collapse. The problem with that single block is "individual risk". For example, if a company goes bankrupt due to poor management, that's normal, and the market will absorb it on its own.

However, if you pull out a critical, core block that supports many other blocks, the entire tower will come crashing down. The risk that causes the entire tower to collapse is "systemic risk".

In the financial world, these blocks are banks, securities firms, insurance companies, funds, and so on. They are interconnected and mutually supportive through loans, investments, guarantees, and other means. Systemic risk refers not to the risk of a single bank or company failing, but to the risk that its failure will trigger a chain reaction, like the first domino falling, ultimately leading to the paralysis or collapse of the entire financial system, or even the entire economy.

The 2008 financial crisis is the most typical example. Lehman Brothers, an investment bank (a critical block), collapsed. It turned out that it owed money to countless banks and companies, and countless other companies had bought financial products it issued. Once it fell, all the "blocks" that had business dealings with it began to loosen. Mutual distrust spread, and no one dared to lend money to each other. The "lubricant" of the entire system (i.e., capital flow) instantly dried up, ultimately leading to a global financial tsunami.

Why is it so dangerous?

The danger of systemic risk lies in its "contagious" and "destructive" nature. It can amplify a localized small problem into a disaster from which no one can escape.

1. Uncontrollable Scope of Impact: Individual risk is like a leaky pipe in your house; fixing it only affects your household. Systemic risk, however, is like the city's main water supply pipe bursting, cutting off water to the entire city. Once it erupts, it won't stay confined to the financial sector but will quickly spread to every corner of the real economy.

2. It directly harms ordinary people:

   • Unemployment: Banks become reluctant to lend, companies can't get funds to expand production, or even struggle to maintain operations. The result is layoffs, salary cuts, and many people losing their jobs.
   • Shrinking Savings and Investments: Stock markets and funds plummet, and your hard-earned retirement savings or down payment for a house could evaporate by more than half in a short period. Although deposit insurance exists, the panic during a system collapse is immeasurable.
   • Difficulty Obtaining Loans: Applying for a mortgage, car loan, or a loan for a small business becomes extremely difficult because banks, struggling themselves, will raise lending standards sky-high.
   • Social Panic: The most terrifying aspect is that it destroys "confidence". When people lose faith in banks, in the government, and in the entire economy, they will rush to banks for runs, and sell off all assets. This panic itself accelerates the system's collapse, creating a vicious cycle.

In summary: The danger of systemic risk lies in its ability to trigger a "financial avalanche". It might start as a small patch of snow (the bankruptcy of one company), but as it rolls down, it gathers more and more snow, eventually forming a massive avalanche that engulfs everything. In the face of such an avalanche, neither large corporations nor ordinary people can easily escape. This is why governments and regulatory bodies worldwide place such immense importance on "preventing systemic financial risk."