Quantitative Risk Management: A Practical Guide to Financial Risk, + Website

4.1 Systemic versus Idiosyncratic Risk

As discussed in Chapter 1, an important distinction exists between idiosyncratic risk and systemic risk. Idiosyncratic risk arises from within a firm and is generally under the control of the firm and its managers. Systemic risk is shared across firms and is often the result of misplaced government intervention, inappropriate economic policies, or misaligned macroeconomic incentives.

The distinction between idiosyncratic and systemic risks is important because in the aftermath of a systemic crisis, such as that of 2007–2009, they often become conflated in discussions of the crisis. Overall, this book focuses on idiosyncratic risk, but this chapter discusses examples of both idiosyncratic and systemic risk. We will see that systemic risk has been and continues to be a feature of banking and finance for both developed and developing economies. Importantly, the costs of systemic events dwarf those of idiosyncratic events by orders of magnitude. From a societal and macroeconomic perspective, systemic risk events are by far the more important.

The distinction between idiosyncratic and systemic disasters is also important because the sources and solutions for the two are quite different. The tools and techniques in this book are directed toward measuring, managing, and mitigating idiosyncratic risk but are largely ineffective against systemic risk. Identifying and measuring systemic risk resides more in the realm of macroeconomics than in quantitative ...