# Understanding Systemic Risk in Banking: Definition, Causes, and Key Examples

![The sign for Lehman Brothers headquarters](https://www.investopedia.com/thmb/5Y2DEj41Oby7isx3ClrXNEVk28c=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Systemicrisk-7602921fb7104332a9930bd7bbd23b84.jpg)

*— NICHOLAS ROBERTS / Stringer / Getty Images*

## What Is Systemic Risk?

Systemic risk is the possibility that a company-level event could destabilize or collapse an entire industry or economy. It played a major role in the [financial crisis](https://www.investopedia.com/terms/f/financial-crisis.asp) of 2008, when institutions deemed "[too big to fail](https://www.investopedia.com/terms/t/too-big-to-fail.asp)" threatened global stability.

Such risk arises from firms that are large or deeply interconnected within the financial system. While government intervention can help prevent widespread collapse, it also sparks debate over market fairness and economic freedom. Systemic risk differs from [systematic risk](https://www.investopedia.com/terms/s/systematicrisk.asp), which affects the entire market or economy.

### Key Takeaways

*   Systemic risk can trigger severe instability across an entire industry or economy from a single company-level event.
*   The 2008 financial crisis highlighted the impact of systemic risk on global markets and economies.
*   Companies deemed "too big to fail" are significant sources of systemic risk due to their size and interconnectedness.
*   The Dodd-Frank Act was enacted to prevent future crises by regulating financial institutions to limit systemic risk.
*   Lehman Brothers' collapse and AIG's bailout underscore the potential fallout of unmanaged systemic risks.

## How Systemic Risk Impacts the Economy

The federal government uses systemic risk as a justification—an often correct one—to intervene in the economy. The government believes it can lessen the ripple effects of a company-level event using targeted rules and actions.

> **Important**
>
> Although some companies are considered "too big to fail," they will if the government does not intervene during turbulent economic times.

However, sometimes the government will choose not to intervene simply because the economy at that time had undergone a major rise and the general market needs a breather. This is more often the exception than the rule, since it can destabilize an economy more than projected due to consumer sentiment.

## Key Examples of Systemic Risk in Financial History

The Dodd-Frank Act of 2010, fully known as [Dodd-Frank Wall Street Reform and Consumer Protection Act](https://www.investopedia.com/terms/d/dodd-frank-financial-regulatory-reform-bill.asp), introduced an enormous set of new laws that are supposed to prevent another Great Recession from occurring by tightly regulating key financial institutions to limit systemic risk. Many debate whether changes to the reforms are needed to help small businesses grow.

Lehman Brothers’ size and integration into the U.S. economy made it a source of systemic risk. When [the firm collapsed](https://www.investopedia.com/articles/economics/09/lehman-brothers-collapse.asp), it created problems throughout the [financial system](https://www.investopedia.com/terms/f/financial-system.asp) and the economy. Capital markets froze up while businesses and consumers could not get loans, or could only get loans if they were extremely creditworthy, posing minimal risk to the lender.

Simultaneously, AIG was also suffering from serious financial problems. Like Lehman, AIG’s interconnectedness with other financial institutions made it a source of systemic risk during the financial crisis. AIG's portfolio of assets tied to subprime mortgages and its participation in the [residential mortgage-backed securities (RMBS)](https://www.investopedia.com/terms/r/rmbs.asp) market through its securities-lending program led to collateral calls, a loss of liquidity, and a downgrade of AIG's credit rating when the value of those securities dropped.

While the U.S. government did not bail out Lehman, it decided to bail out AIG with loans of more than $180 billion, preventing the company from going bankrupt. Analysts and regulators believed that an [AIG bankruptcy](https://www.investopedia.com/articles/economics/09/american-investment-group-aig-bailout.asp) would have caused numerous other financial institutions to collapse as well.

## The Bottom Line

Systemic risk refers to the potential for a single company's failure to trigger widespread economic instability, as seen during the 2008 financial crisis with the collapse of Lehman Brothers and the bailout of AIG.

These events revealed how deeply interconnected large financial institutions are and why government measures like the Dodd-Frank Act were introduced to curb future crises.

Understanding systemic risk helps investors and financial professionals assess market stability, recognize vulnerabilities, and anticipate the regulatory responses that aim to protect the broader economy.

> **Article Sources**
>
> 1.  Congressional Research Service. “[Financial Regulation: Systemic Risk](https://crsreports.congress.gov/product/pdf/R/R47026),” Pages 1-2.
>     
> 2.  Commodity Futures Trading Commission. “[Dodd-Frank Act](https://www.cftc.gov/LawRegulation/DoddFrankAct/index.htm).”
>     
> 3.  Congressional Research Service. “[Financial Regulation: Systemic Risk](https://crsreports.congress.gov/product/pdf/R/R47026),” Page 3.
>     
> 4.  Federal Reserve Bank of New York. “[Actions Related to AIG](https://www.newyorkfed.org/aboutthefed/aig).”
>     
> 5.  Congressional Research Service. “[Financial Regulation: Systemic Risk](https://crsreports.congress.gov/product/pdf/R/R47026),” Page 9.
>     
> 6.  U.S. Department of the Treasury. “[AIG Program Status](https://home.treasury.gov/data/troubled-assets-relief-program/aig/status).”