Which of the following best defines systemic risk?

Systemic risk is best defined as the risk that the failure of one financial institution or a cluster of institutions could lead to a broader market collapse, significantly affecting the entire financial system. This concept highlights how interconnectedness among financial institutions can create vulnerabilities, where the distress of one entity can trigger contagion effects, leading to widespread financial instability.

This definition emphasizes the systemic nature of financial markets, where individual failures do not only threaten the institution itself but can also lead to a domino effect, causing other institutions to fail due to their interdependent relationships. Thus, the potential for systemic risk to create a chain reaction in the financial sector makes it a critical area of focus for regulators and risk managers.

In contrast, the other options address risks but do not encapsulate the comprehensive nature of systemic risk. Market fluctuations, for example, can affect individual investors or institutions without necessarily leading to systemic breakdown. Similarly, loan defaults and regulatory non-compliance represent specific risks that may impact single entities but not necessarily signal the potential for widespread systemic failure.