Systemic Risk

The danger lies in the links between parties. Banks lend to each other, hold similar assets, depend on the same payment systems and trade in the same markets. When one fails or a market freezes, losses and fear spread through those links. Sources of spread are often grouped as direct exposures between firms, many firms selling the same assets at once, and loss of confidence that makes funding vanish. A shared service provider or a clearing house can also act as a single point of failure. Systemic risk cannot be removed by each firm managing itself well, because the cost of a collapse falls on others. Authorities respond with extra capital for the biggest institutions, stress tests, resolution plans and oversight of key infrastructure. Economic damage from such crises reaches well beyond the firms that start them, so authorities supervise the links as well as the firms.

A securities dealer cannot meet its payments and defaults on trades with twenty counterparties. Several of them are short of cash and sell government bonds to cover the gap, which pushes prices down. Other holders face valuation losses and margin calls. A problem in one dealer becomes a market-wide shortage of funding.