Systemic risk
Topic: Banking Regulation, NPAs and Financial Stability · NCERT: Beyond NCERT
Meaning
Systemic risk is the danger that the failure of one institution or market sets off a chain of failures across the whole financial system, and then the economy. It spreads in three main ways:
- Interconnectedness: institutions owe each other money.
- Common exposures: many institutions hold the same assets.
- Fire sales: forced selling pushes prices down for everyone.
Regulators track systemic risk through the FSDC (2010), which is chaired by the Finance Minister, and through RBI's Financial Stability Report.
Example
In September 2018, IL&FS defaulted. Mutual funds and banks held debt papers issued by NBFCs, so they suffered losses and became cautious. Funding for other NBFCs froze. The DHFL crisis followed in 2019.
Don't confuse with
- Idiosyncratic risk: this is risk specific to one firm, such as a single bad loan or one fraud. It does not spread to the rest of the system.
Related concepts
- Letter of undertaking
- Know Your Customer
- Legal Entity Identifier
- Ponzi scheme
- Chit fund
- Subprime lending
- Stress test