Systematic Risk

Many economists are worried about systematic risk. This is the risk that an entire system or market will collapse in chain reaction response to the collapse of one instituion.

Michael Rozeff clarifies the issue.

Systemic risk is a function of the risks that an individual firm takes on. A firm that lends to a Bear Stearns is actually supposed to investigate the credit-worthiness of Bear. It is not supposed to put all of its eggs in one Bear basket. A firm that obtains a credit default guarantee from AIG is actually supposed to check up on AIG and find out if that guarantee means anything or whether it’s just an empty promise...

Systemic risk is mitigated when individual firms mitigate their own risks. It is not mitigated when those risks are centralized in a few large firms with a government backup. That creates systemic risk. Decentralization and risk-avoidance mitigate systemic risk.

In other words, if all banks mitigate risk correctly, systematic risk disappears.