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203
Contagion in financial networks
- Proceedings of the Royal Society A: Mathematical, Physical and Engineering Science
"... This paper develops an analytical model of contagion in financial networks with arbitrary structure. We explore how the probability and potential impact of contagion is influenced by aggregate and idiosyncratic shocks, changes in network structure, and asset market liquidity. Our findings suggest th ..."
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Cited by 97 (1 self)
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This paper develops an analytical model of contagion in financial networks with arbitrary structure. We explore how the probability and potential impact of contagion is influenced by aggregate and idiosyncratic shocks, changes in network structure, and asset market liquidity. Our findings suggest that financial systems exhibit a robust-yet-fragile tendency: while the probability of contagion may be low, the effects can be extremely widespread when problems occur. And we suggest why the resilience of the system in withstanding fairly large shocks prior to 2007 should not have been taken as a reliable guide to its future robustness.
Measuring systemic risk: A risk management approach
- Journal of Banking and Finance
, 2005
"... This paper proposes a new method to measure and monitor the risk in a bank-ing system. Standard tools that regulators require banks to use for their internal risk management are applied at the level of the banking system to measure the risk of a regulator’s portfolio. Using a sample of international ..."
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Cited by 63 (1 self)
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This paper proposes a new method to measure and monitor the risk in a bank-ing system. Standard tools that regulators require banks to use for their internal risk management are applied at the level of the banking system to measure the risk of a regulator’s portfolio. Using a sample of international banks from 1988 until 2002, I estimate the dynamics and correlations between bank asset portfolios. To obtain measures for the risk of a regulator’s portfolio, I model the individual liabil-ities that the regulator has to each bank as contingent claims on the bank’s assets. The portfolio aspect of the regulator’s liability is explicitly considered and the methodology allows a comparison of sub-samples from different countries. Corre-lations, bank asset volatility, and bank capitalization increase for North American and somewhat for European banks, while Japanese banks face deteriorating capital levels. In the sample period, the North American banking system gains stability while the Japanese banking sector becomes more fragile. The expected future lia-bility of the regulator varies substantially over time and is especially high during the Asian crisis starting in 1997. Further analysis shows that the Japanese banks contribute most to the volatility of the regulator’s liability at that time. Larger and more profitable banks have lower systemic risk and additional equity capital reduces systemic risk only for banks that are constrained by regulatory capital requirements.
Interbank market integration under asymmetric information. European Central Bank. European Central Bank, Working Paper 74
, 2001
"... Cross-country bank lending appears to be subject to market imperfections leading to persistent interest rate differentials. In a model where banks need to cope with liquidity shocks by borrowing or by liquidating assets, we study the scope for international interbank market integration with unsecure ..."
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Cited by 57 (9 self)
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Cross-country bank lending appears to be subject to market imperfections leading to persistent interest rate differentials. In a model where banks need to cope with liquidity shocks by borrowing or by liquidating assets, we study the scope for international interbank market integration with unsecured lending when cross-country information is noisy. We find that an equilibrium with integrated markets need not always exist, and that it may coexist with one characterized by segmenta-tion. A repo market reduces interest rate spreads and improves upon the segmenta-tion equilibrium. However, it may destroy the unsecured integrated equilibrium. The objective of this article is to study the effects of cross-country asym-metric information on the structure of financial markets. Our main con-cern is the design of money markets and the role of repo and (unsecured) interbank markets in an international framework, but our results carry over to a more general framework of the analysis of cross-country direct investment, covering the cross-country market both for bonds and equity. The creation of an integrated interbank market is particularly relevant in order for banks to cope efficiently with liquidity shocks. Interbank mar-kets are instrumental in allowing for a smooth working of the payment systems (so that a bank that is lacking liquidity in the payment system is able to borrow from another bank), and in channeling liquidity to the banks and countries that need it most. Both repo and unsecured interbank lending allow banks to cope with liquidity shocks. Still, because unsecured markets are based on peer monitoring, they introduce market discipline, thus playing the role unsecured deposits may play when depositors receive information [Calomiris and Kahn (1991)]. The collapse of a well-functioning unsecured interbank market proved to be crucial in the context of Eastern Asia financial crises where
Liasons Dangereuses: Increasing Connectivity, Risk Sharing, and Systemic risk,” Unpublished working paper.
, 2009
"... Abstract We characterize the evolution over time of a network of credit relations among financial agents as a system of coupled stochastic processes. Each process describes the dynamics of individual financial robustness, while the coupling results from a network of liabilities among agents. The av ..."
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Cited by 50 (11 self)
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Abstract We characterize the evolution over time of a network of credit relations among financial agents as a system of coupled stochastic processes. Each process describes the dynamics of individual financial robustness, while the coupling results from a network of liabilities among agents. The average level of risk diversification of the agents coincides with the density of links in the network. In addition to a process of diffusion of financial distress, we also consider a discrete process of default cascade, due to the re-evaluation of agents assets. In this framework we investigate the probability of individual defaults as well as the probability of systemic default as a function of the network density. While it is usually thought that diversification of risk always leads to a more stable financial system, in our model a tension emerges between individual risk and systemic risk. As the number of counterparties in the credit network increases beyond a certain value, the default probability, both individual and systemic, starts to increase. This tension originates from the fact that agents are subject to a financial accelerator mechanism. In other words, individual financial fragility feeding back on itself may amplify the effect of an initial shock and lead to a full fledged systemic crisis. The results offer a simple possible explanation for the endogenous emergence of systemic risk in a credit network.
Network structure and systemic risk in banking systems
, 2012
"... We present a quantitative methodology for analyzing the potential for contagion and sys-temic risk in a network of interlinked financial institutions, using a metric for the systemic importance of institutions: the Contagion Index. We apply this methodology to a data set of mutual exposures and capi ..."
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Cited by 44 (3 self)
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We present a quantitative methodology for analyzing the potential for contagion and sys-temic risk in a network of interlinked financial institutions, using a metric for the systemic importance of institutions: the Contagion Index. We apply this methodology to a data set of mutual exposures and capital levels of financial institutions in Brazil in 2007 and 2008, and analyze the role of balance sheet size and network structure in each institution’s contribution to systemic risk. Our results emphasize the contri-bution of heterogeneity in network structure and concentration of counterparty exposures to a given institution in explaining its systemic importance. These observations plead for capital requirements which depend on exposures, rather than aggregate balance sheet size, and which
Interbank contagion in the Dutch banking sector: Sensitivity Analysis
- The International Journal of Central Banking
, 2006
"... We investigate interlinkages and contagion risks in the Dutch interbank market. Based on several data sources, includ-ing survey data, we estimate the exposures in the interbank market at bank level. Next, we perform a scenario analysis to measure contagion risks. We find that the bankruptcy of one ..."
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Cited by 44 (1 self)
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We investigate interlinkages and contagion risks in the Dutch interbank market. Based on several data sources, includ-ing survey data, we estimate the exposures in the interbank market at bank level. Next, we perform a scenario analysis to measure contagion risks. We find that the bankruptcy of one of the large banks will put a considerable burden on the other banks but will not lead to a complete collapse of the interbank market. The exposures to foreign counterparties are large and warrant further research. An important contribu-tion of this paper is that we show, using survey data, that the entropy estimation using large exposures data as applied in many previous papers gives an adequate approximation of the actual linkages between banks. Hence, this methodology does not seem to introduce a bias. JEL Codes: G15, G20. 1.
Networks in Finance
- In The Network
, 2009
"... Abstract Modern …nancial systems exhibit a high degree of interdependence. There are different possible sources of connections between …nancial institutions, stemming from both the asset and the liability side of their balance sheet. For instance, banks are directly connected through mutual exposur ..."
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Cited by 29 (0 self)
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Abstract Modern …nancial systems exhibit a high degree of interdependence. There are different possible sources of connections between …nancial institutions, stemming from both the asset and the liability side of their balance sheet. For instance, banks are directly connected through mutual exposures acquired on the interbank market. Likewise, holding similar portfolios or sharing the same mass of depositors creates indirect linkages between …nancial institutions. Broadly understood as a collection of nodes and links between nodes, networks can be a useful representation of …nancial systems. By providing means to model the speci…cs of economic interactions, network analysis can better explain certain economic phenomena. In this paper we argue that the use of network theories can enrich our understanding of …nancial systems. We review the recent developments in …nancial networks, highlighting the synergies created from applying network theory to answer …nancial questions. Further, we propose several directions of research. First, we consider the issue of systemic risk. In this context, two questions arise: how resilient …nancial networks are to contagion, and how …nan-cial institutions form connections when exposed to the risk of contagion. The second issue we consider is how network theory can be used to explain freezes in the interbank market of the type we have observed in August 2007 and subsequently. The third issue is how social networks can improve investment decisions and corporate governance. Recent empirical work has provided some interesting results in this regard. The fourth issue concerns the role of networks in distributing primary issues of securities as, for example, in initial public o¤erings, or seasoned debt and equity issues. Finally, we consider the role of networks as a form of mutual monitoring as in micro…nance.
Systemic risk and stability in financial networks. American Economic Review forthcoming.
, 2014
"... Abstract We provide a framework for studying the relationship between the financial network architecture and the likelihood of systemic failures due to contagion of counterparty risk. We show that financial contagion exhibits a form of phase transition as interbank connections increase: as long as ..."
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Cited by 26 (0 self)
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Abstract We provide a framework for studying the relationship between the financial network architecture and the likelihood of systemic failures due to contagion of counterparty risk. We show that financial contagion exhibits a form of phase transition as interbank connections increase: as long as the magnitude and the number of negative shocks affecting financial institutions are sufficiently small, more "complete" interbank claims enhance the stability of the system. However, beyond a certain point, such interconnections start to serve as a mechanism for propagation of shocks and lead to a more fragile financial system. We also show that, under natural contracting assumptions, financial networks that emerge in equilibrium may be socially inefficient due to the presence of a network externality: even though banks take the effects of their lending, risk-taking and failure on their immediate creditors into account, they do not internalize the consequences of their actions on the rest of the network.
Settlement risk under gross and net settlement
- Journal of Money Credit and Banking
, 2003
"... Abstract: Previous comparative analyses of gross and net settlement have focused on the credit risk of the central counterparty in net settlement arrangements, and on the incentives for participants to alter the risk of the portfolio under net settlement. By modeling the trading economy that generat ..."
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Cited by 26 (2 self)
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Abstract: Previous comparative analyses of gross and net settlement have focused on the credit risk of the central counterparty in net settlement arrangements, and on the incentives for participants to alter the risk of the portfolio under net settlement. By modeling the trading economy that generates the demand for payment services, we are able to show some largely unexplored advantages of net settlement. We find that net settlement systems avoid certain gridlock situations, which may arise in gross settlement in the absence of delivery versus payment requirements. In addition, net settlement can economize on collateral requirements and avoid trading delays.
