Getting to grips with systemic risks
Eva Cairns
Head of Responsible Investment
New report explores how investors can better identify, understand and tackle systemic risks.
A recent report co-authored by Scottish Widows explores the scale and scope of systemic risk and how investors can better identify, understand and tackle them.
Systemic risks can have wide-ranging impacts across markets and economies. Their interactions can spark a cascade of consequences that can be damaging and disruptive, affecting the stability of financial markets. That’s why understanding what systemic risks are and addressing them is so crucial to build more resilient pension portfolios and a more sustainable future for pension savers.
What are systemic risks?
“Systemic risks are undiversifiable risks that can impact entire markets or economic systems, through complex interconnections, potentially triggering chain reactions across multiple sectors and undermining overall market growth.”1
Societies and economies face a number of systemic risks in today’s world, including issues such as geopolitics, inequality, climate change, biodiversity loss, trade wars, and artificial intelligence. The World Economic Forum’s Global Risks Report, 20252 highlights the key global risks as identified and ranked by business leaders, many of which can be considered systemic risks:
The top three short-term risks are: misinformation and disinformation; extreme weather events; state-based armed conflict.
Longer term, extreme weather events are the top global risk over 10 years.
Source: World Economic Forum Global Risks Perceptions Study 2024-25.
Meanwhile, results from the Bank of England’s Systemic Risk Survey for the second half of 2024, showed, for example, that geopolitical risk and cyber attacks are the risks most cited by participants, and the risks considered most challenging to manage3.
Recent times have seen two systemic risks unfold – the global financial crisis and the global pandemic. By examining the effects of those, we can clearly see the impacts on multiple sectors, society and the economy, as well as the systems of global trade. There are also lessons to be learned from those crises, which could maybe help investors better manage and mitigate risks in the future.
How systemic risks affect investors
The potential impact of systemic risks on investors and pension savers can be significant. These may include sharp falls in financial markets that can take time to recover, and loss of investor confidence.
The very nature of systemic risks – that they are interconnected, broad-ranging and have repercussions lasting a long time – can make an investor’s usual risk-management tools less effective. Investors cannot simply diversify away from systemic risks given their wide-ranging impact across asset classes, sectors and regions.
It’s yet another reason why, as an industry, we need to step up to address systemic risks and to help to create resilient portfolios that can support investor confidence.
Managing systemic risk is challenging
Taking a proactive approach to systemic risk and factoring it into portfolio management and stewardship policies, is therefore becoming more important. But it isn’t easy.
Systemic risks are complex and significant. In a recent report by UKSIF co-authored by Scottish Widows, ‘Systemic risks: a framework for portfolio resilience’, we recognised a number of industry challenges related to tackling systemic risks:
- Misalignment of incentives – Incentives for asset managers are often driven by short-term performance, making it difficult to incorporate long-term challenges. They also tend to take a company-focused approach to deliver outperformance, rather than consider the overall health and stability of financial markets that drives the majority of pension saver returns.
- Influencing change – Tackling systemic risks requires collective action, but first-movers may take the bulk of the work while others can enjoy the benefits as ‘free riders’.
- Measuring the impacts – There is a lack of conventional metrics to measure the impacts of systemic risks, and they are hard to translate to materiality.
- Understanding terminology – There is a lack of understanding of systemic risk.
Addressing the challenges
Although policymakers and regulators will naturally bear some of the burden of addressing systemic risks, asset owners, managers, advisers and investors also have roles to play, and there are a number of considerations for them.
- Ensuring that systemic risk is understood and factored into investment decision-making, balancing it with other investment objectives.
- Engaging with investee companies to understand potential impacts in areas such as supply chains or how policy translates into the real world.
- Engaging with the wider system that investee companies operate in – policymakers, regulators, standard setters, wider industry and asset managers.
- Promoting collaboration and coordinating action between investors and others.
Looking ahead
While it’s hard to predict the next event that could expose systemic risks, there are some clues that can help us prepare. We know, for example, that climate change poses a systemic risk to economies, businesses and societies, by causing widespread damage through natural disasters and extreme weather, disrupting supply chains, transport and displacing people. We’re also seeing a heightening of geopolitical tension and potential trade wars.
Identifying systemic risks and understanding their impact, as well as ensuring that the management of these risks is part of a robust approach to investing and responsible stewardship, will mean that more resilient portfolios can be created. That can lead to better outcomes for pension savers and for society more generally.
For use by UK employers and advisers only.