How can systemic risk impact the financial market as a whole?

Systemic risk refers to the potential for a failure in one part of the financial system to lead to a chain reaction that impacts the entire market or economy. The reason that systemic risk can cause the collapse of the entire financial system lies in the interconnectedness of financial institutions, markets, and instruments. When one major entity faces distress, it can negatively affect others through various channels such as credit, liquidity, and contagion effects.

For example, the collapse of a large bank can lead to a loss of confidence among investors and other banks, prompting a withdrawal of funds, a freeze in lending, and a rapid decline in asset prices across the market. This can escalate quickly, leading to a widespread crisis that affects many sectors, undermining the stability of the financial system as a whole.

In contrast, options that suggest systemic risk would only impact a few companies, enhance market stability, or improve investor confidence do not accurately reflect the nature of systemic risk, as these outcomes are more aligned with localized issues or positive economic conditions rather than the pervasive and detrimental effects of systemic risk.