Systemic risk (supposedly generated in free markets) has been one of the FED myths of late (also called financial fragility). Bernanke favors it and even wrote an article about it in 1990 in which he said that it is an important concern of regulators. This past December, he justified the bailouts of AIG, Citigroup, Fannie and Freddie, and others by reduction in systemic risk.
An academic paper that is forthcoming in one of the top three finance journals documents “that systemic risk is limited even in major financial crises.” See the abstract here.
In fact, it is irrational for everyone to link hands and all be forced to fall over a cliff if one person stumbles and falls over the edge. A profit-maximizing business (banks included) takes many measures to insulate itself from being brought down by others, and the evidence in this paper suggests that they do their job.
A cluster of failures can occur. They do not come from any inherent weakness in the system due to over-dependencies and excessive linkages, which is what systemic risk suggests is going on. They come from correlated errors induced by the previous boom, and these are typically brought on by government policies and ills of the banking systems.
