What is meant by 'systemic risk' in finance?

Systemic risk refers to the potential failure of an entire financial system or market, as opposed to the risk associated with a single entity or isolated incidents. It arises from the interconnections within the financial system, whereby the failure of a large institution or multiple institutions can trigger widespread instability that affects the functioning of the entire market or economic structure.

This type of risk is particularly significant because it can lead to cascading failures and significant economic downturns, as seen prominently during financial crises like the 2008 global financial meltdown. The interconnectedness of financial institutions means that distress in one can lead to a loss of confidence and subsequently impact others, underlining the importance of systemic risk in financial stability discussions.

Market fluctuation refers to changes in security prices due to various factors but does not specifically encompass the notion of systemic failure. Similarly, average risk in a diversified portfolio relates to the reduction of unsystematic risk through diversification, which doesn't capture the essence of systemic risk, which is about the collective behavior of the system as a whole. Lastly, the risk associated with a single entity focuses on idiosyncratic risk rather than the broader, systemic implications that affect the entire financial system.