Contagion Systemic Risk In Financial Networks

This volume presents a unified mathematical framework for the transmission channels for damaging shocks that can lead to instability in financial systems. As the title suggests, financial contagion is analogous to the spread of disease, and damaging financial crises may be better understood by bringing to bear ideas from studying other complex systems in our world. After considering how people have viewed financial crises and systemic risk in the past, it delves into the mechanics of the interactions between banking counterparties. It finds a common mathematical structure for types of crises that proceed through cascade mappings that approach a cascade equilibrium. Later chapters follow this theme, starting from the underlying random skeleton graph, developing into the theory of bootstrap percolation, ultimately leading to techniques that can determine the large scale nature of contagious financial cascades.

The Handbook on Systemic Risk, written by experts in the field, provides researchers with an introduction to the multifaceted aspects of systemic risks facing the global financial markets. The Handbook explores the multidisciplinary approaches to analyzing this risk, the data requirements for further research, and the recommendations being made to avert financial crisis. The Handbook is designed to encourage new researchers to investigate a topic with immense societal implications as well as to provide, for those already actively involved within their own academic discipline, an introduction to the research being undertaken in other disciplines. Each chapter in the Handbook will provide researchers with a superior introduction to the field and with references to more advanced research articles. It is the hope of the editors that this Handbook will stimulate greater interdisciplinary academic research on the critically important topic of systemic risk in the global financial markets.

Financial network analysis is used to provide firm level bottom-up holistic visualizations of interconnections of financial obligations in global OTC derivatives markets. This helps to identify Systemically Important Financial Intermediaries (SIFIs), analyse the nature of contagion propagation, and also monitor and design ways of increasing robustness in the network. Based on 2009 FDIC and individually collected firm level data covering gross notional, gross positive (negative) fair value and the netted derivatives assets and liabilities for 202 financial firms which includes 20 SIFIs, the bilateral flows are empirically calibrated to reflect data-based constraints. This produces a tiered network with a distinct highly clustered central core of 12 SIFIs that account for 78 percent of all bilateral exposures and a large number of financial intermediaries (FIs) on the periphery. The topology of the network results in the “Too- Interconnected-To-Fail” (TITF) phenomenon in that the failure of any member of the central tier will bring down other members with the contagion coming to an abrupt end when the ‘super-spreaders’ have demised. As these SIFIs account for the bulk of capital in the system, ipso facto no bank among the top tier can be allowed to fail, highlighting the untenable implicit socialized guarantees needed for these markets to operate at their current levels. Systemic risk costs of highly connected SIFIs nodes are not priced into their holding of capital or collateral. An eigenvector centrality based ‘super-spreader’ tax has been designed and tested for its capacity to reduce the potential socialized losses from failure of SIFIs.

The recent financial crisis and the difficulty of using mainstream macroeconomic models to accurately monitor and assess systemic risk have stimulated new analyses of how we measure economic activity and the development of more sophisticated models in which the financial sector plays a greater role. Markus Brunnermeier and Arvind Krishnamurthy have assembled contributions from leading academic researchers, central bankers, and other financial-market experts to explore the possibilities for advancing macroeconomic modeling in order to achieve more accurate economic measurement. Essays in this volume focus on the development of models capable of highlighting the vulnerabilities that leave the economy susceptible to adverse feedback loops and liquidity spirals. While these types of vulnerabilities have often been identified, they have not been consistently measured. In a financial world of increasing complexity and uncertainty, this volume is an invaluable resource for policymakers working to improve current measurement systems and for academics concerned with conceptualizing effective measurement.

This paper studies the interconnectedness of the global financial system and its susceptibility to shocks. A novel multilayer network framework is applied to link debt and equity exposures across countries. Use of this approach—that examines simultaneously multiple channels of transmission and their important higher order effects—shows that ignoring the heterogeneity of financial exposures, and simply aggregating all claims, as often done in other studies, can underestimate the extent and effects of financial contagion.The structure of the global financial network has changed since the global financial crisis, impacted by European bank’s deleveraging and higher corporate debt issuance. Still, we find that the structure of the system and contagion remain similar in that network is highly susceptible to shocks from central countries and those with large financial systems (e.g., the USA and the UK). While, individual European countries (excluding the UK) have relatively low impact on shock propagation, the network is highly susceptible to the shocks from the entire euro area. Another important development is the rising role of the Asian countries and the noticeable increase in network susceptibility to shocks from China and Hong Kong SAR economies.

This Technical Note on Systemic Risk and Contagion Analysis on Switzerland summarizes the systemic risk and contagion analysis undertaken for the Swiss financial system as part of the Financial Sector Assessment Program (FSAP) Update. Contagion risks arising from interbank exposures in Switzerland appear to be contained. This analysis shows only moderate effects, consistent with restrictions imposed by the Swiss ‘large exposure rules’ currently in place, and no material second round effects will materialize within the domestic interbank market. In terms of bank groups, domestic interbank exposure risks appear to be moderate for most banks, but a few small private banks and banks specialized in asset management appear to be somewhat vulnerable. The international contagion analysis suggests that global contagion risks among Global Systemically Important Financial Institutions and the large Swiss financial institutions appear to be currently contained. The systematic risk analysis shows that the relative contribution of domestically oriented banks to systemic risk is increasing. The bank-sovereign contagion analysis suggests that increases in banks capital buffers have contributed positively to limit contagion risks.

This paper presents a novel approach to investigate and model the network of euro area banks’ large exposures within the global banking system. Drawing on a unique dataset, the paper documents the degree of interconnectedness and systemic risk of the euro area banking system based on bilateral linkages. We develop a Contagion Mapping model fully calibrated with bank-level data to study the contagion potential of an exogenous shock via credit and funding risks. We find that tipping points shifting the euro area banking system from a less vulnerable state to a highly vulnerable state are a non-linear function of the combination of network structures and bank-specific characteristics.

Modern financial systems exhibit a high degree of interdependence, with connections between financial institutions stemming from both the asset and the liability sides of their balance sheets. Networks--broadly understood as a collection of nodes and links between nodes--can be a useful representation of financial systems. By modeling economic interactions, network analysis can better explain certain economic phenomena. In this chapter, Allen and Babus argue that the use of network theories can enrich our understanding of financial systems. They explore several critical issues. First, they address the issue of systemic risk, by studying two questions: how resilient financial networks are to contagion, and how financial institutions form connections when exposed to the risk of contagion. Second, they consider how network theory can be used to explain freezes in the interbank market. Third, they examine how social networks can improve investment decisions and corporate governance, based on recent empirical results. Fourth, they examine the role of networks in distributing primary issues of securities. Finally, they consider the role of networks as a form of mutual monitoring, as in microfinance.