Systemic Risk — When One Collapse Spreads to the Whole

Systemic risk is the risk that the failure of one institution or market spreads to the entire financial system through an interconnected network.

Unlike individual risk (a problem with one stock or one company), systemic risk spreads through 'contagion.' When A collapses, B, which had traded with A, takes a loss, and B's distress passes to C, and so on.

Financial institutions are tightly connected — lending money to one another, entering derivatives contracts, and sharing assets. In normal times this connection raises efficiency, but in a crisis it becomes a channel that spreads losses quickly.

That's why the phrase 'too big to fail' arises — because the collapse of one place can bring down the whole.

An early case in which the world felt systemic risk was LTCM (Long-Term Capital Management) in 1998.

LTCM was a hedge fund that even included Nobel laureates, but it used extreme leverage. With equity capital of about $4.8 billion, it borrowed more than $125 billion, so its leverage reached about 25 to 30 times, and the notional size of its derivatives contracts exceeded $1 trillion.

When its bets went wrong in the 1998 Russian crisis, LTCM was pushed to the brink of collapse. The problem was that this fund was entangled with almost every major financial institution on Wall Street, so a disorderly liquidation would have shaken world markets.

In the end, arranged by the Federal Reserve, 14 financial institutions injected about $3.6 billion to wind it down in an orderly way (this was the money of private banks, not Fed funds).

The 2008 Lehman Brothers bankruptcy is the event in which systemic risk became not a 'possibility' but a 'reality.'

Lehman was entangled with institutions worldwide through derivatives trades with a notional value of about $35 trillion. When Lehman collapsed, those losses spread to its counterparties, and the fear of 'who's next?' froze the funding markets.

Even institutions that had no direct dealings with Lehman found their funding cut off and fell into a liquidity crisis. The collapse of one place spread across the entire system.

After this experience, countries strengthened mechanisms to reduce systemic risk — regulating large financial institutions more tightly and expanding central counterparties, among others.

Systemic risk is a macro risk that individuals cannot control. But knowing this concept helps you understand why markets collapse so quickly and so broadly in a crisis.

In a crisis phase, almost all assets fall together regardless of whether an individual asset is good or bad (correlations converge toward 1). This is why diversification can look temporarily powerless.

So the preparations an individual can make are: (1) avoiding excessive leverage, (2) keeping a share of cash and safe assets that can withstand a crisis, and (3) bracing in advance for the maximum drawdown and the drawdown duration. This is also why this service emphasizes drawdown and recovery period.