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A critical review of contagion risk in banking
Abstract
The recent financial crisis has focused the attention of scholars and policymakers on how to improve financial stability through better macro‐prudential regulation and supervision. In this paper, we compare the existing theoretical and empirical literature on contagion through the banking system. It is argued that the structure of the interbank market, the size of banks, the linkages among them, the level of correlation of their investments and the transparency of the regulator are key factors in determining the possibility of contagion. We discuss the different findings and present avenues for future research.
... One common driver of interconnectedness is economic transactions among financial institutions which comprise the so-called "financial network" (Upper, 2011). A growing body of evidence shows that characteristics of the financial network have important economic implications for contagion risk and the stability of particular financial markets (e.g., Billio et al., 2012;Hasman, 2013;Acemoglu, Ozdaglar, and Tahbaz-Salehi, 2015). Financial network characteristics also can affect individual economic agents' decisions and performance (e.g., Li and Schurhoff, 2014). ...
... The banking system has been most extensively analyzed (European Central Bank, 2010;Hasman, 2013;Minoiu and Reyes, 2013); and the literature has expanded to other financial markets, such as credit default swaps (CDS) (Markose, Giansante, and Shaghaghi, 2012;Getmansky, Girardi, and Lewis, 2016) and global insurance markets (Billio et al., 2012;Kanno, 2016). ...
Reinsurance is the primary source of interconnectedness in the insurance industry. As such, reinsurance connectivity provides a transmission mechanism for financial shocks and potentially exposes insurers to contagion and systemic risk. In this article, connectivity within the U.S. property–casualty (P/C) reinsurance market is modeled as a network. We model the network of all primary insurers and reinsurers in the market. We analyze all bilateral reinsurance counterparty relationships (domestic and foreign) of U.S. P/C insurers, and we model both intra‐ and intergroup transactions. We extend the prior literature by providing a detailed examination of the reinsurance network structure, including network density, network components, centrality of individual insurers, and sub‐network analysis for top insurers. Our analysis of contagion and insolvency risk reveals that even the failure of the top 10 in‐degree or in‐strength insurers with 100 percent loss given default would not lead to widespread insolvencies in the U.S. P/C insurance industry.
... and measures of liquidity and solvency Hasman (2013), Chinazzi and Fagiolo (2013), Upper (2011) and Allen and Babus (2009) Surveys of narrow (contagious) events Survey of theory and empirical work on contagion; survey of network formation; survey of simulation work on contagion; background on networks and contagion Cappiello et al. (2010), Bernanke and Gertler (2010), Kashyap and Stein (2000) and Bernanke et al. (1999) Vertical events Theory and empirics making case that financial sector impacts real sector Degryse and Nguyen (2007), Roukny et al. (2013) and Hüser (2015) Narrow (contagious) events and network structure Empirical work and simulation study displaying importance of network structure; survey of empirical and theoretical interbank network research Daníelsson et al. (2013), Daníelsson and Shin (2003), Daníelsson and Zigrand (2012), Madhavan (2012), Zigrand (2010) and Thurner and Poledna (2013) De Bandt also extends this taxonomy to include horizontal systemic events as those that occur only in the financial sector without spreading to the general economy, and vertical events as those with spillovers to real activity. While a great deal of systemic risk research reviewed here focuses on the financial sector alone-and therefore horizontal events-the more interesting events are arguably vertical events in which the financial sector has negative impacts on the broader economy. ...
... The risk of contagion is very specific to both the markets being considered, and the timing of exogenous events that might stress a system (Degryse and Nguyen 2007;Roukny et al. 2013;Hasman 2013). At this time there is little research or understanding of the linkages and synergies of multiple layered-or multiplex-markets. ...
The financial crisis led to a number of new systemic risk measures and a renewed concern over the risk of contagion. This paper surveys the systemic risk literature with a focus on the importance of contributions made by those emphasizing a network-based approach, and how that compares with more commonly used approaches. Research on systemic risk has generally found that the risk of contagion through domino effects is minimal, and thus emphasized focusing on the resiliency of the financial system to broad macroeconomic shocks. Theoretical, methodological, and empirical work is critically examined to provide insight on how and why regulators have emphasized deregulation, diversification, size-based regulations, and portfolio-based coherent systemic risk measures. Furthermore, in the context of network analysis, this paper reviews and critically assesses newly created systemic risk measures. Network analysis and agent-based modeling approaches to understanding network formation offer promise in helping understand contagion, and also detecting fragile systems before they collapse. Theory and evidence discussed here implies that regulators and researchers need to gain an improved understanding of how topology, capital requirements, and liquidity interact.
... One common driver of interconnectedness is economic transactions among financial institutions which comprise the so-called "financial network" (Upper, 2011). A growing body of evidence has shown that characteristics of the financial network have important economic implications for contagion risk and the stability of particular financial markets (Billio et al., 2012;Kaushik and Battiston, 2012;Markose, Giansante, and Shaghaghi, 2012;Hasman, 2013;Acemoglu, Ozdaglar, and Tahbaz-Salehi, 2015b). The Financial Crisis of 2007-2008 is a good example. ...
... It is therefore not surprising that there is a fast growing literature concerning the financial stability of various financial markets using network analysis. In the financial network literature, the banking system has been most extensively analyzed (European Central Bank, 2010;Hasman, 2013). The literature has expanded from banking to other financial systems, such as credit default swaps (CDS) (Kaushik and Battiston, 2012;Markose, Giansante, and Shaghaghi, 2012;Roukny, Georg, and Battiston, 2014), the global banking market (Minoiu and Reyes, 2013), global financial and insurance markets (Billio et al., 2012), and the global derivatives market (Markose, 2012). ...
... Recently, Ding et al. [38] developed a model to detect community structures based on stock co-jump dependence. Simultaneous and intertemporal co-jumps are also related to the theme of contagion; see Forbes and Rigobon [41], Bae et al. [14], Allen et al. [8], Billio et al. [21], Bisias et al. [22], Hasman [44], Diebold and Yilmaz [37], Hautsch et al. [45], Acharia et al. [2], Acharya et al. [3], Acemoglu et al. [1], Adrian and Brunnermeier [4], Brownlees and Engle [27], and the references therein. ...
We study how jumps spillover and the cross-company impact of firm-specific unscheduled news on jumps between economic sectors. To this end, we employ high-frequency data of 220 constituents of the Russell 3000 index equally divided into eleven sectors. Using conditional jump probabilities, we find that jump spillover is a pervasive phenomenon enhanced when jumps cluster and that firm-specific news, especially from the financial sector, boosts the jump spillover effect. Volatility following spillover jumps is significantly higher than usual, except when firm-specific news is released around the jump provoking the spillover.
... For example, it could attempt to mitigate contagion risk by obligating large-scale AI providers to give general information about how its models might be linked to open source materials or other resources potentially shared across models. 210 Moreover, the AI agency can highlight specific issues or sub-issues that are receiving materially more scrutiny in expert literature or where engineering developments are resolving legal questions or ameliorating legal risks. Thus, such an agency would be well-positioned to help entities across the administrative state answer meta-questions of "how to think about how to think about" regulating AI. ...
This Article contributes to the legal literature on artificial intelligence (AI) regulation by recognizing an operational paradox: the tension between 1) users' growing adoption of AI technologies or providers across nearly all different federal agency jurisdictions, and 2) a growing need for focused direction of AI policy to advance metapolicies addressing issues like growing geopolitical competitive concerns. The Article scrutinizes the Senate-proposed Digital Platform Commission Act of 2023 and the less-controlled nature of adaptive governance to conclude that neither a comprehensively powerful agency nor a solely ground-level focus on AI use can resolve the operational paradox. Instead, this Article recognizes the inadequacy of current regulatory assets like OIRA and NIST and instead proposes that the paradox can be resolved by Congress's creation of a new agency vested with both coordinating and limited compulsory powers over other agencies and private entities. Specifically, this AI agency can be formed as some combination of three ex-ante and ex-post archetypes: an advance guard, a first responder, and a post-hoc investigator. The Article then details practical policy examples for each of these archetypes from existing federal entities such
... Many scholars have considered a number of issues, along with several influential factors as the concerns in the IMM (Acharya et al., 2012;Angelini et al., 2011;Bernard & Bisignano, 2000;Dičpinigaitienė & Novickytė, 2018;Furfine, 2003;Martínez-Jaramillo et al., 2010). Although several researchers have already surveyed various aspects of this market (Arman, 2013;Caccioli et al., 2017;Dičpinigaitienė & Novickytė, 2018;Hasman, 2013;Pozlep, 2018), to the best of our knowledge, there is still a lack of a comprehensive study that identifies the roots of major concerns and integrate them into the body of knowledge of this field. To answer the question that on what basis various market players make their liquidity supply/demand decisions, this study collects as much data as possible on their main concerns and the origins of each concern. ...
As the reallocator of liquidity from banks with excess to banks with a deficit, the interbank money market (IMM) plays a fundamental role in the proper functioning of the banking system and the economy as a whole. The aggregate uncertainty derived from stochasticity of the overall level of the demand for short-term liquidity and the likelihood of domino failures of tightly connected competitors who lend themselves vast amounts of liquidity explains the complexity of decisions in this environment. To identify the most significant factors influencing actors’ strategies, we first present the five underlying patterns discovered through a bibliometric analysis of 609 scientific documents in this field: contagion and systemic risk, stability, market structure, relationship and trust, and default and failure. Then, our detailed study findings on 160 recent works indicate elements that affect central banks’ strategies in reducing systemic risk and preventing financial contagion, as well as managing the interbank network in a way that makes it more stable and resilient to shocks to conserve market confidence. Furthermore, they address factors that influence banks’ strategies to maintain their lending relationships and mitigate default risk. In addition to summarizing potential research directions, this paper provides market participants with a strategy fact-sheet.
... Studies show that the networks formed by banks and other financial institutions have the characteristics of being scale-free or small world. Furthermore, complex network theories and methods are being used in research on financial risk contagion (; Du, Zhang, & Ying, 2018;González-Avella, Quadros, & Iglesias, 2016;Hasman, 2013;Joe, 2018;Kenett, Perc, & Boccaletti, 2015;Podobnik, Horvatic, & Lipic, 2015;Ribeiro, Alves, & Martins, 2018). Bhattacharya et al. (2020) used network analysis to reveal that more actively borrowing banks in the network also help increase credit risk. ...
Financial regulation is the basic requirement for financial stability. Recently, regulatory technology (Reg-Tech) has become one of the main research topics in financial stability regulation. Reg-Tech aims to use artificial intelligence technologies to realize intelligent identification and early risk warning. It is a powerful tool for assisting financial regulation informatization and high efficiency. This study aims to comprehensively review the application of smart technology in financial stability regulation, and analyze the objects and results of the technology's applications. We build a framework for the application of complex networks, knowledge graphs, machine learning, and dynamic systems in Reg-Tech. The aim is to form a clear context for its development, and serve as the support and development foundation for financial stability research. Finally, we summarize the limitations and shortcomings of current Reg-Tech developments, and discuss future research and development directions.
... Systemic risk and risk management is an integral part of the modern-day banking system. The contagious nature of systemic risk and its enormous influence on financial health and stability of the world are considered an essential part of the contemporary monetary environment (Kenourgios et al., 2016;Yarovaya et al., 2020;Kahlert et al., 2017), where the contagion of systemic risk can be defined as a "financial value or liquidity shock" which spreads from one to another organization of the structure (Hasman, 2013;Dasgupta, 2004;Cifuentes et al., 2005;Baker et al., 2016;Batten et al., 2017). In this regard, different authors have taken different approaches to determine the effect of this crucial topic. ...
Purpose
This study aims to examine the systemic risk contagion in banks from 15 US states using extreme shocks in their distance to risk.
Design/methodology/approach
The authors contemplate a model that inputs co-exceedances in the base US states’ banking sector as the dependent variable and the co-exceedances in other states’ banking sector (along with other underlying variables of a banking system) as the explanatory variables.
Findings
The authors find smaller states transmit and receive more systemic shocks than their larger counterparts and larger states exhibit a better shock-resisting capacity than their smaller counterparts. The authors also find that bigger shocks are more contagious than the smaller shocks.
Originality/value
This will be the first paper that will investigate the inner linkage of US states’ banking network using three different distance to risk methods, thus providing timely guidance for regulators.
... The survey of empirical work on contagion can refer to [147]. Empirical studies are revealing that financial contagion can not be well explained by the base model of obligation default ( [101,135,145,148). ...
The Covid-19 pandemic has brought about a heavy impact on the world economy, which arouses growing concerns about potential systemic risk, taking place in countries and regions. At this critical moment, it makes sense to interpret the systemic risk from the perspective of the financial crisis framework. By combing the latest research on systemic risks, we may arrive at some precautions relating to the current events. This literature review verifies the origin of systemic risk research. By comparing the retrieved and screened systemic literature with the relevant research on the financial crisis, more focus on the micro-foundations of systemic risk has been discovered. Besides, the measurement methods of systemic risks and the introduction of interdisciplinary methods have made the research in this field particularly active. This paper synthesizes the previous research conclusions to find the appropriate definition of systemic risk and combs the research literature of systemic risk from two lines: Firstly, conducting the division according to the sub-branch fields within the financial discipline and the relevant interdisciplinary research methods, which is helpful for scholars within and outside the discipline to have a more systematic understanding of the research in this field. Secondly predicting the research direction that can be expanded in this field.
... An important difference between their study and ours, however, is that we explicitly evaluate the transmission of risks beyond the banking sector, using a sample of CDS spreads that includes a large number of nonfinancial corporations. For a comprehensive review on risk spillovers we refer the reader to two related literature surveys by Hasman (2013) and Chinazzi and Fagiolo (2015). One feature of the literature is the overwhelming emphasis on the transmission of risks between banks and sovereigns. 2 Augustin et al. (2018) and Bedendo and Colla (2015) are exceptions. ...
We use a factor model and elastic net shrinkage to model a high‐dimensional network of European CDS spreads. Our empirical approach allows us to assess the joint transmission of bank and sovereign risk to the non‐financial corporate sector. Our findings identify a sectoral clustering in the CDS network, where financial institutions are in the center and non‐financial entities as well as sovereigns are grouped around the financial center. The network has a geographical component reflected in different patterns of real‐sector risk transmission across countries. Our framework also provides dynamic estimates of risk transmission, a useful tool for systemic risk monitoring.
... Instead, there is a growing consensus that policymakers should adopt a macro-prudential approach to regulation and supervision. The macro-prudential approach (Basel III) views the financial system as a whole by taking the effect of systemic risk into account (Galati and Moessner, 2013;Hasman, 2013). By considering the framework of micro-prudential and macro-prudential regulations together, we propose several concrete intervention policies for bailing out systemically important financial institutions--by forced mergers or capital injections where the systemic important financial institutions are either the institutions with higher bilateral exposures or the institutions with higher interconnectedness. ...
Recent financial turmoil (e.g., the 2008–2009 global financial crisis) has resulted in financial contagion-induced instability becoming one of the major concerns in the fields of economics and finance. In this paper, we extend the network analysis of financial contagion from three perspectives. First, given that cross-holding of claims and obligations among financial institutions can be viewed as input-output linkages, we model the financial system and the contagion mechanism by introducing the classic Leontief input–output framework. Second, based on this modeling process, we propose a simple contagion algorithm to study how financial system heterogeneity influences its stability. Third, to mitigate financial contagion, we propose several concrete intervention policies based on two widely used prudential approaches—forced mergers and capital injections. The performance of these intervention policies is then evaluated by comprehensive numerical experiments. Our study has significant implications for financial regulation and supervision.
... The standard factor model (Fama and French 1993) posits a strong relation between risk and return, but ignores any possible spillovers of risk between stocks or risk portfolios. Interestingly, contagion risk between banks and markets have been noted in the literature (see, for example, Kodres and Pritsker 2002;Hasman 2013), but not between risk portfolios. However, if there were any such spillovers, this would point to an alternate source of risk propagated not only by the factors, but through spillovers. ...
This paper develops a new identification result for the causal ordering of observation units in a recursive network or directed acyclic graph. Inferences are developed for an unknown spatial weights matrix in a spatial lag model under the assumption of recursive ordering. The performance of the methods in finite sample settings is very good. Application to data on portfolio returns produces interesting new evidences on the contemporaneous lead–lag relationships between the portfolios and generates superior predictions.
... Ever since the recent financial crisis, studies in interdependencies in the context of risk management have increased rapidly with most of them showing a great interest in the dependency structure within financial sector, i.e. financial contagion (Rodriguez 2007, May & Arinaminpathy 2010, Hasman 2013, Georg 2013, Acemoglu et al. 2015. However, as broad asset allocation including industry assets becomes more and more popular, interdependency among industries started to attract more attention as well. ...
This paper contributes to model the industry interconnecting structure in a network context. General predictive model (Rapach et al. 2016) is extended to quantile LASSO regression so as to incorporate tail risks in the construction of industry interdependency networks. Empirical results show a denser network with heterogeneous central industries in tail cases. Network dynamics demonstrate the variety of interdependency across time. Lower tail interdependency structure gives the most accurate out-of-sample forecast of portfolio returns and network centrality-based trading strategies seem to outperform market portfolios, leading to the possible ’too central to fail’ argument.
... The literature on cross-country contagion effects measured only in the financial sector is relatively limited. Hasman (2013) provides an overview, pointing out that much of this work is related to the literature on prudential regulation. ...
... Even though financial crises were a frequent feature of the twentieth century, it is only in recent times, following the Subprime Crisis of 2008-2009, that the network theory has been extensively used to study financial contagion by economists and financial regulators [11][12][13]. The seminal literature of [3] pioneers this strand of theoretical study by showing how the network structure affects risk sharing. ...
... 18 In Diamond and Dybvig (1983) and the subsequent literature, deposit insurance tends to be an optimal policy as it deals with the threat of self-fulfilling runs on banks -a consequence of incomplete information on the part of some agents. Deposit insurance can thus potentially prevent from a 'domino effect' of financial bankruptcies and severe damage to the banking system, see Iyer and Puri (2012) and Hasman (2013). In addition, Bhattacharya et al. (1998) argue that deposit insurance financed by taxation is generally superior to suspensions of bank withdrawals as a bank run prevention tool. ...
In what contexts is it desirable that the government, rather than the private sector, takes on the role of an insurer and helps people reduce risks? Our discussion implies that while in a number of areas individuals benefit from well-designed insurance provided by their government, ill-designed public policies (for example existing pay-as-you-go pension systems) force individuals to insure against their government. It is further discussed how governments could improve their risk managing role in many areas by using income contingent loans, provided the country has high-quality institutions and governance. Such loans to artists, sportspeople, flood victims or collapsing financial institutions would replace the existing nonrepayable transfers, grants, subsidies and bailouts. Using a simple efficiency-equity-sustainability framework for comparing income contingent schemes with conventional public and private insurance policies, we document that this would enable governments to extend their insurance assistance to a greater number of people and institutions – in a way that is not only equitable but also efficient and fiscally sustainable.
... This choice is made with the aim of investigating and measuring the amount of spillover that could be explained by the transmission channels, as summarized by the network, and of prescribing an intervention in order to reduce spillover and mitigate risk. Our methodol-ogy thus relates to previous analyses pointing at what is called direct contagion as opposed to informational contagion (see Allen et al. (2009);Hasman (2013)). ...
We propose a spatial approach for modeling risk spillovers using financial time-varying proximity matrices based on observable networks. We show how these methods could be useful in (i) isolating risk channels, risk spreaders and risk receivers, (ii) investigating the role of portfolio composition in risk transfer, and (iii) computing target exposure structures able to reduce the forecasted system variance and thus the risk of the system. Our empirical analysis builds on banks’ foreign exposures provided by the Bank of International
Settlements (BIS) as a proxy for Euro area cross-country holdings. We find, in the European sovereign bond markets, that Germany, Italy and, to a lesser extent, Greece are playing a central role in spreading risk, and Ireland and Spain are the most susceptible receivers of spillover effects that can be traced back to a physical claim channel: banks’ foreign exposures. We additionally show that acting on these physical channels before the sovereign crisis, it would have been possible to have a clear risk mitigation outcome.
Systemic risk represents a critical challenge in modern financial systems characterized by complex interconnections. This chapter comprehensively analyses systemic risk, exploring its measurement, models, determinants, interconnections, and the key variables influencing its dynamics. One of the central focuses of this chapter is to explore the transmission channels through which systemic risk propagates. By analyzing various channels, including contagion risk, credit risk, liquidity risk, market risk, operational risk, and macroeconomic risk, the chapter unveils the mechanisms through which disruptions can spread across financial institutions, markets, and economies. The interconnected nature of these channels is also emphasized to showcase the amplification of systemic risk. The interconnections between financial institutions and markets are crucial factors of systemic risk. We discuss the significance of network analysis and emphasize the importance of considering both visible and hidden (shadow) interconnections when assessing systemic risk. By identifying the vulnerabilities and interdependencies within the financial system, policymakers could then develop targeted measures to mitigate systemic risks. The chapter highlights the need for proactive monitoring, enhanced risk management practices, and coordinated regulatory efforts across jurisdictions. These policy implications could then strengthen the financial system’s resilience and reduce the likelihood of systemic crises.
The global food and agricultural trade network is crucial for food security. Shocks such as those posed by extreme weather events, conflicts, pandemics, and economic crises can test the resilience of the trade network to the sudden interruption of trade flows. Depending on the level of connectivity in the trade network and its structure, such shocks have the potential to propagate through the entire network and can affect countries’ food availability and variety. The paper contributes to the literature on food and agricultural trade networks in two main ways: (1) understanding the global trade network as a complex system that can be affected by and responds to shocks, we define and operationalize its resilience as a multidimensional concept which is shaped by the interdependencies in the network and their structure; (2) applying techniques from network analysis to examine the evolution of three dimensions of resilience within the global food and agricultural trade network between 1995 and 2019. The main findings show that, between 1995 and 2007, trade connectivity among countries increased. Overall, this bolstered countries’ and the network's resilience to trade shocks. However, vulnerabilities persisted in terms of ensuring sufficient product variety and quantity. Adding to these vulnerabilities, trade integration stalled in the second half of the series, pointing to a slight tendency towards trade disintegration and potentially lower resilience of countries to trade shocks already in 2019.
Purpose
The present study aims to comprehensively examine the impact of the Union Bank of Switzerland (UBS) takeover of Credit Suisse on the banking and financial services sector in the Indian stock market. To fully comprehend the impact of the event, the study separately investigates the response of private sector banks, public sector banks, overall banking companies and financial services companies to the takeover of the second-largest financial institution in Switzerland.
Design/methodology/approach
The study employs event study methodology, using the market model, to analyze the event's impact on Indian banking and financial services sector stocks. The data consists of daily closing prices of companies included in the Nifty Private Bank Index, Nifty PSU Bank Index, Nifty Bank Index and Nifty Financial Services Index from the National Stock Exchange (NSE). Furthermore, cross-sectional regression analysis has been conducted to explore the factors that drive abnormal returns.
Findings
The empirical findings of the study suggest the event had a heterogeneous impact on the stock prices of Indian banks and financial services companies. While public sector banks experienced a significant negative impact on select days within the event window, the overall Indian banking sector and financial services companies also witnessed notable declines. In contrast, Indian private sector banks were relatively resilient, exhibiting minimal effects. However, the cumulative effect is found to be insignificant for all four categories across different event windows. The study also observed that the cumulative abnormal returns (CARs) were significantly influenced by certain variables during different event windows.
Originality/value
To the best of the authors' knowledge, the present study is the earliest attempt that investigates the impact of the UBS takeover of Credit Suisse on the Indian banking and financial services sector using event study methodology and cross-sectional regression model.
This Article contributes to the legal literature on artificial intelligence (AI) regulation by recognizing an operational paradox: the tension between 1) users’ growing adoption of AI technologies or providers across nearly all different federal agency jurisdictions, and 2) a growing need for focused direction of AI policy to advance metapolicies addressing issues like growing geopolitical competitive concerns. The Article scrutinizes the Senate-proposed Digital Platform Commission Act of 2023 and the less-controlled nature of adaptive governance to conclude that neither a comprehensively powerful agency nor a solely ground-level focus on AI use can resolve the operational paradox. Instead, this Article recognizes the inadequacy of current regulatory assets, like the Office of Information and Regulatory Affairs and the National Institute of Standards and Technology, and therefore proposes that the paradox can be resolved by Congress’s creation of a new agency vested with both coordinating and counterintuitively limited compulsory powers over other agencies and private entities. Specifically, this AI agency can be formed as some combination of three ex-ante and ex-post archetypes: an advance guard, a first responder, and a post-hoc investigator. The Article then details practical policy examples for each of these archetypes from existing federal entities such as the Federal Emergency Management Agency, the Federal Deposit Insurance Corporation, the Federal Aviation Administration, and the National Transportation Safety Board.
The purpose of this paper is to investigate the publication trends in banking regulations (as defined by the Basel Accords) influencing the growth and performance of banks across geographical regions and suggest possible future research opportunities. A bibliometric analysis is undertaken to study the publication trends over a period of three decades. The network linkages have been explored by means of science mapping techniques. Various indicators, such as most-cited authors, citation analysis, h-index, affiliations, and funding sponsors, have been used. Identification of research hubs provides opportunities for research collaboration and knowledge sharing among nations. The research pattern observed can be utilised in the creation of regulatory frameworks for integrated and seamless cross-border financial transactions. The findings indicate an urgent need for more research on banking regulations and supervision and how they influence the performance of the banks, especially in emerging markets.
This paper uses an agent-based model to construct an interbank network for the Chinese interbank market using a sample of 299 commercial banks from 2014 to 2019. We analyze the importance and vulnerability of banks using the DebtRank algorithm. Our results show that the Chinese interbank market bears a certain level of systemic risk, especially among lower-tiered banks. The results also show a bank is more vulnerable if it has a higher interbank lending ratio and greater financial connectivity. Meanwhile, a bank is more influential if it has a larger net worth and greater financial connectivity
In this paper, we study the asymptotic behavior of three types of Marginal Expected Shortfalls with different reference indices of the overall risk. Our results for the asymptotic independence case are obtained under quite general frameworks, in which no specific distribution class of each individual risk is supposed. For the asymptotic dependence case, we conduct the study under two widely applied assumptions, which imply that the individual risks possess the Fréchet and Gumbel tails, respectively. We also give an analysis on the accuracy of our asymptotic results in various scenarios when there are two individual risks in the whole system.
Purpose
Interdependency among industries is vital for understanding economic structures and managing industrial portfolios. However, it is hard to precisely model the interconnecting structure among industries. One of the reasons is that the interdependencies show a different pattern in tail events. This paper aims to investigate industry interdependency with the tail events.
Design/methodology/approach
General predictive model of Rapach et al. (2016) is extended to an interdependency model via least absolute shrinkage and selection operator quantile regression and network analysis. A dynamic network approach was applied on the Fama–French industry portfolios to study the time-varying interdependencies.
Findings
A denser network with heterogeneous central industries is found in tail cases. Significant interdependency varieties across time are shown under dynamic network analysis. Market volatility is identified as an influential factor of industry connectedness as well as clustering tendency under both normal and tail cases. Moreover, combining dynamic network with prediction direction information into out-of-sample industry return forecasting, a lower tail case is obtained, which gives the most accurate prediction of one-month forward returns. Finally, the Sharpe ratio criterion prefers high-centrality portfolios when tail risks are considered.
Originality/value
This study examines the industry portfolio interactions under the framework of network analysis and also takes into consideration tail risks. The combination of economic interpretation and statistical methodology helps in having a clear investigation of industry interdependency. Moreover, a new trading strategy based on network centrality seems profitable in our data sample.
We consider a financial network where banks are heterogeneous in scale and each bank has only local knowledge regarding the network. Each bank must make counterparty and portfolio decisions while anticipating uncertainty regarding the network structure. Such network uncertainty is an important consideration in banks’ risk management practice, which aims to minimize the effect of exogenous liquidity shocks and hedge against possible fire-sale in asset markets. We show that network uncertainty gives rise to an endogenous core-periphery structure which is optimal in mitigating financial contagion yet concentrates systemic risk at the core of big banks.
We construct the causal complex network of financial institution based on the Granger-causality network as well as the principal component analysis, and further analyze the network topology structure characteristics using centrality indicators. From the perspective of time dimension and space dimension, the causal complex network among financial institutions is analyzed with the dynamic variation of systemic risk measured. One improvement is that the CAPM is employed to filter out the market risk. Moreover, we study the contribution of individual financial firm to the systemic risk through three well known systemic risk measures containing the systemic risk index (SRISK), the marginal expected shortfall (MES) and the conditional Value at Risk (CoVaR). The proposed methodology framework is applied to the banks, securities and insurance companies in Chinese financial markets. Empirical researches find that the causal network of Chinese financial entities possesses small world and scale free properties, with the number of connections increasing dramatically in turmoil periods, indicating stronger interconnectedness in the financial system during crisis. Moreover, the network based connectedness measures through topology structure analysis can identify and quantify the financial crisis, serving as significant systemic risk indicators. In addition, different systemic risk measures employed in our framework can identify similar rankings of risky financial firms quantitatively, which provide references for regulations.
Contrary to the common approach of stress-testing under which banks are evaluated whether they are distressed, this empirical study chooses to move from the micro stress test approach to a wider new macro stress test category. By being able to stress testing the entire economy of the Eurozone, it will permit big banks to fail and, at the same time, will open room for new banking players to enter the sector, promoting the essence of a healthy destruction. The analysis performs a battery of stress tests, by implementing VaR, Cornish-Fisher VaR, Monte Carlo VaR, Expected Shortfall, Cornish-Fisher Expected Shortfall, and Monte Carlo Expected Shortfall. At the same time, it explicitly considers the new regulatory approach of IFRS9 to incorporate extreme values from forecasted series in the distributions. The analysis also performs two versions of stress tests, one including TARGET2 and one without it. The results document that future stress tests should include TARGET2 values in order to capture a better picture of the stressed economy. The findings from these stress tests clearly illustrate that although there has been a trough after the distress call of 2008, this trough ended. These are results derived without including the TARGET2 transfers. By including the TARGET2 transfers we receive a different picture that possibly acts as a protective mechanism against any future crisis. Caution is still advised, possibly due to some lingering imbalances within the Eurozone.
This paper studies the default risk contagion in banking systems based on a dynamic network model with two different kinds of lenders’ selecting mechanisms, namely, endogenous selecting (ES) and random selecting (RS). From sensitivity analysis, we find that higher risk premium, lower initial proportion of net assets, higher liquid assets threshold, larger size of liquidity shocks, higher proportion of the initial investments and higher Central Bank interest rates all lead to severer default risk contagion. Moreover, the autocorrelation of deposits and lenders’ selecting probability have non-monotonic effects on the default risk contagion, and the effects differ under two mechanisms. Generally, the default risk contagion is much severer under RS mechanism than that of ES, because the multi-money-center structure generated by ES mechanism enables borrowers to borrow from more liquid banks with lower interest rates.
The increase in the frequency and scope of financial crises has made the stability and robustness of the financial system a major concern in the field of finance worldwide. Due to the interconnectedness between institutions, the negative effects of financial crises spread through the financial system in a process referred to as financial contagion. In this study, we focus on a financial system in which large numbers of financial institutions are connected by direct balance sheet linkages through their lending-borrowing relationships. We mainly focus on modeling and analyzing financial contagion from a network analytics perspective. First, we model the financial system and the mechanism of contagion by introducing the concepts of exposure matrix, book value, market value and liquidation cost. Second, we propose a simple contagion algorithm based on this modeling process. Third, we study the effects of the financial system's heterogeneity on the magnitude of financial contagion by applying the proposed algorithm. The level of heterogeneity is measured by the diversification of exposure ratio and the extent of network connectivity. According to the results of our comprehensive numerical simulation, we conclude that an increase in heterogeneity has a significant influence on the stability of the financial system. Our study has significant implications for the practice of financial regulation and surveillance.
Financial contagion is an attractive topic in recent years, since it is one of the most important issues closely related to the financial systemic risk that could seriously hurt the economy. This review aims to summarize and clarify the different concepts and measurements of financial contagion investigated in the literatures and try to highlight their common feature and differences. Noting that “structural break” is the essential feature used to define financial contagion, most of the measurements of financial contagion proposed in the literature are along the line of modeling structural break according to different mechanisms. Although, a few measurements could be used to investigate financial contagion, there remain hardships in real applications. The emerging “Big Data” technology might be helpful to refine both the research and the practice of risk management relevant to financial contagion in model specification and information acquisition.
Understanding the connectivity of international financial markets is critical to understanding the origination and propagation of financial crises. This study investigates the contribution of US and European exchange rate interactions to overall stress in the US financial system from 1992 to 2013. The impacts of these interactions are assessed using a financial stress index that aggregates measures of national and international stresses. There are three main findings for the sample period. First, we find that European influences on US financial stress have increased. Second, observing several structural breaks with changing correlation and Granger causality patterns, we find that the euro and the British pound have contributed varying levels of stress. Third, we find that stress in US markets tends to spill over into European markets, while the reverse influences are of lesser importance. These findings have important implications for supervisors in international markets. Understanding the amplifying or attenuating feedback effects from international connectivity provides valuable insight into the development of macroprudential policies.
This article presents an analysis of the literature on systemic financial risk. To that end, we analyze and classify 266 articles that were published no later than September 2016 in the databases Scopus and Web of Knowledge; these articles were identified using the keywords “systemic risk”, “financial stability”, “financial”, “measure”, “indicator”, and “index”. They were evaluated based on 10 categories, namely, type of study, type of approach, object of study, method, spatial scope, temporal scope, context, focus, type of data used, and results. The analysis and classification of this literature made it possible to identify the remaining gaps in the literature on systemic risk; this contributes to a future research agenda on the topic. Moreover, the most influential articles in this field of research and the articles that compose the mainstream research on systemic financial risk were identified.
This chapter critically surveys the recent empirical literature applying complex-network techniques to the study of macroeconomic dynamics. We focus on three important macroeconomic networks: international trade, finance and migration/mobility. We discuss both the empirical evidence on the topological properties of these networks and econometric works that identify the impact of network properties on macroeconomic dynamics. Results indicate that a detailed knowledge of macroeconomic networks is necessary to better understand the dynamics of country income, growth and productivity, as well as the diffusion of crises.
The global financial crisis (2007-2009) saw sharp declines in stock markets around the world, affecting both advanced and emerging markets. In this paper we test for the existence of equity market contagion originating from the US to advanced and emerging markets during the crisis period. Using a latent factor model, we provide strong evidence of contagion effects in both advanced and emerging equity markets. In the aggregate equity market indices, contagion from the US explains a large portion of the variance in stock returns in both advanced and emerging markets. However, in the financial sector indices we find less evidence of contagion than in the aggregate indices, and this is particularly the case for the advanced markets. The results suggest that contagion effects are not strongly related to high levels of global integration.
To date, various central banks have lacked detailed statistical evidence on developments in the unsecured interbank money market. Furfine (1999) introduced the idea of calculating unsecured overnight interbank lending by using data of a RTGS system. Based on data from the Swiss payment system (SIC) we developed an algorithm to identify unsecured interbank loans in Swiss francs. In contrast to Furfine (1999) we also identify longer-term transactions. We thereby gain a deeper insight on the size and structure of the unsecured interbank money market in Swiss francs. This is the first time that SIC data have been used to identify transactions and market rates in the unsecured Swiss franc money market. Overall, the estimates show that after the collapse of Lehman Brothers loss of confidence led to a freezing-up of the market for several months and a decrease in daily turnover.
This paper analyzes the effects of financial integration on the stability of the banking system. Financial integration allows banks in different regions to smooth local liquidity shocks by borrowing and lending on a world interbank market. We show under which conditions financial integration induces banks to reduce their liquidity holdings and to shift their portfolios toward more profitable but less liquid investments. Integration helps reallocate liquidity when different banks are hit by uncorrelated shocks. However, when a correlated (systemic) shock hits, the total liquid resources in the banking system are lower than in autarky. Therefore, financial integration leads to more stable interbank interest rates in normal times but to larger interest rate spikes in crises. These results hold in a setup in which financial integration is welfare improving from an ex ante point of view. We also look at the model’s implications for financial regulation and show that, in a second-best world, financial integration can increase the welfare benefits of liquidity requirements.
The online appendix is available at https://doi.org/10.1287/mnsc.2017.2841 .
This paper was accepted by Neng Wang, finance.
Systemic risk among the network of international banking groups arises when financial stress threatens to criss-cross many national boundaries and expose imperfect international co-ordination. To assess this risk, we apply an information theoretic map equation due to Martin Rosvall and Carl Bergstrom to partition banking groups from 21 countries into modules. The resulting modular structure reflects the flow of financial stress through the network, combining nodes that are most closely related in terms of the transmission of stress. The modular structure of the international banking network has changed dramatically over the past three decades. In the late 1980s four important financial centres formed one large supercluster that was highly contagious in terms of transmission of stress within its ranks, but less contagious on a global scale. Since then the most influential modules have become significantly smaller and more broadly contagious. The analysis contributes to our understanding as to why defaults in US sub-prime mortgages had such large global implications.
Do low interest rates alleviate banking fragility? Banks finance illiquid assets with demandable deposits, which discipline bankers but expose them to damaging runs. Authorities may choose to bail out banks being run. Unconstrained bailouts undermine the disciplinary role of deposits. Moreover, competition forces banks to promise depositors more, increasing intervention and making the system worse off. By contrast, constrained intervention to lower rates maintains private discipline, while offsetting contractual rigidity. It may still lead banks to make excessive liquidity promises. Anticipating this, central banks can reduce financial fragility by raising rates in normal times to offset their propensity to reduce rates in adverse times.Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.
Banks face two moral hazard problems: asset substitution by shareholders (e.g., making risky, negative net present value loans) and managerial rent seeking (e.g., investing in inefficient “pet” projects or simply being lazy and uninnovative). The privately-optimal level of bank leverage is neither too low nor too high: It balances efficiently the market discipline imposed by owners of risky debt on managerial rent-seeking against the asset-substitution induced at high levels of leverage. However, when correlated bank failures can impose significant social costs, regulators may bail out bank creditors. Anticipation of this generates an equilibrium featuring systemic risk in which all banks choose inefficiently high leverage to fund correlated assets. A minimum equity capital requirement can rule out asset substitution but also compromises market discipline by making bank debt too safe. The optimal capital regulation requires that a part of bank capital be unavailable to creditors upon failure, and be available to shareholders only contingent on good performance.
This article tests financial contagion due to interbank linkages. For identification, we exploit an idiosyncratic, sudden shock caused by a large-bank failure in conjunction with detailed data on interbank exposures. First, we find robust evidence that higher interbank
exposure to the failed bank leads to large deposit withdrawals. Second, the magnitude of contagion is higher for banks with weaker fundamentals. Third, interbank linkages among surviving banks further propagate the shock. Finally, we find results suggesting that there are real economic effects. These results suggest that interbank linkages act as an important channel of contagion and hold important policy implications.
The version of record [Interbank Contagion at Work: Evidence from a Natural Experiment, Rajkamal Iyer and José-Luis Peydró, The Review of Financial Studies, August 2011, 24(4): 1337-1377] is available online at https://academic.oup.com/rfs/article-abstract/24/4/1337/1578693; DOI: https://doi.org/10.1093/rfs/hhp105. Also available: European Central Bank working paper: https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1147.pdf
In previous studies, the OECD has identified the main hallmarks of the crisis as too-big-to-fail institutions that took on too much risk; insolvency resulting from contagion and counterparty risk; the lack of regulatory and supervisory integration; and the lack of efficient resolution regimes. This article looks at how the Basel III proposals address these issues, helping to reduce the chance of another crisis like the current one. The Basel III capital proposals have some very useful elements, notably a leverage ratio, a capital buffer and the proposal to deal with pro-cyclicality through dynamic provisioning based on expected losses. However, this report also identifies some major concerns. For example, Basel III does not properly address the most fundamental regulatory problem that the “promises” that make up any financial system are not treated equally. This issue has many implications for the reform process, including reform of the structure of the supervision and regulation process and whether the shadow banking system should be incorporated into the regulatory framework – and, if so, how. Finally, modifications in the overall riskweighted asset framework are suggested that would deal with concentration issues.
Purpose
– The purpose of this paper is to show how network analysis can be used for effective cross‐border financial surveillance, which requires the monitoring of direct and indirect systemic linkages.
Design/methodology/approach
– This paper illustrates how network analysis could make a significant contribution in this regard by simulating different credit and funding shocks to the banking systems of a number of selected countries. After that, the authors show that the inclusion of risk transfers could modify the risk profile of entire financial systems, and thus an enriched simulation algorithm able to account for risk transfers is proposed.
Findings
– Finally, the authors discuss how some of the limitations of the simulations are a reflection of existing information and data gaps, and thus view these shortcomings as a call to improve the collection and analysis of data on cross‐border financial exposures.
Originality/value
– This paper is one of the very few to take a cross‐border perspective on financial networks. It is also unique in accounting for risk transfers and in proposing a methodology to include the analysis (and monitoring) of risk transfers into a network model.
The recent subprime crisis has brought back to light proposals to regulate banks’ liquidity as a complement to solvency regulations. Based on recent academic research, I suggest that liquidity regulations might indeed be a way to limit the pressure on Central Banks in favour of liquidity injections during crisis periods. Another crucial question is the allocation of responsibilities between the Central Bank, the Banking Supervisors and the Treasury in the management of banking crises.
In this paper we use credit rating data from two Swedish banks to elicit evidence on these banks’ loan monitoring ability. We do so by comparing the ability of bank ratings to predict loan defaults relative to that of public ratings from the Swedish credit bureau. We test the banks’ abilility to forecast the credit bureau’s ratings and vice versa. We show that one of the banks has a superior predictive ability relative to the credit bureau. This is evidence that bank credit ratings do contain valuable private information and suggests they may be be a reasonable basis for risk management. However, public ratings are also found to have predictive ability for future bank ratings, indicating that risk analysis should be based on both public and bank ratings. The methods we use represent a new basket of straightforward techniques that enable both financial institutions and regulators to assess the performance of credit ratings systems.
We propose a measure for systemic risk: CoVaR, the value at risk (VaR) of the financial system conditional on institutions being in distress. We define an institution’s contribution to systemic risk as the difference between CoVaR conditional on the institution being in distress and CoVaR in the median state of the institution. From our estimates of CoVaR for the universe of publicly traded financial institutions, we quantify the extent to which characteristics such as leverage, size, and maturity mismatch predict systemic risk contribution. We also provide out-of-sample forecasts of a countercyclical, forwardlooking measure of systemic risk and show that the 2006:Q4 value of this measure would have predicted more than half of realized covariances during the financial crisis.
This paper incorporates costly voluntary acquisition of information à la Nikitin and Smith (2007) [Nikitin, M., Smith, R.T., 2007. Information acquisition, coordination, and fundamentals in a financial crisis. Journal of Banking and Finance, in press, doi:10.1016/j.jbankfin.2007.04.031], in a framework similar to Allen and Gale (2000) [Allen, F., Gale, D., 2000. Financial contagion. Journal of Political Economy 108, 1–33], without relying on any unexpected shock to model contagion. In this framework, contagion and financial crises are the result of information gathering by depositors, weak fundamentals and an incomplete market structure of banks. It also shows how financial systems entering a recession can affect others with apparently stronger economic conditions (contagion). Finally, this is the first paper to investigate the effectiveness of the Contingent Credit Line procedures, introduced by the IMF at the end of the nineties, as a mechanism to prevent the propagation of crises.
We examine share-price reactions of commercial bank common stock issues and find negative effects on rival commercial and investment banking firms. In comparison, we find no such intra-industry effects for equity issues by industrial firms. Our results support theoretical models in which bank loan portfolios impound asymmetric information about client firms, so that adverse individual bank announcements generate external information effects on other banks. A policy implication of these results is that regulatory pressures applied to individual banks induce spillover costs for the commercial and investment banking industries. Our evidence also indicates that the legal separation of commercial and investment banking activities is artificial.
We study liquidity transfers between banks through the interbankborrowing and asset sale markets when(i)surplus banks providingliquidity have market power, ii)there are frictions in the lendingmarket due to moral hazard, and(iii)assets are bank-specific. We showthat when the outside options of needy banks are weak, surplus banks maystrategically under-provide lending, thereby inducing inefficient salesof bank-specific assets. A central bank can ameliorate this inefficiencyby standing ready to lend to needy banks, provided it has greaterinformation about banks(e.g.,through supervision) compared to outsidemarkets, or is prepared to extend potentially loss-making loans. Thepublic provision of liquidity to banks, in fact its mere credibility,can thus improve the private allocation of liquidity among banks. Thisrationale for central banking funds support in historical episodespreceding the modern era of central banking and has implications forrecent debates on the supervisory and lender-of-last-resort roles ofcentral banks.
New Approaches to Monetary Economics brings together presentations of innovative research in the field of monetary economics. Much of this research develops and applies approaches to modelling financial intermediation, aggregate fluctuations, monetary aggregation and transactions-motivated monetary equilibrium. The contents of this volume comprise the proceedings of the second in a conference series entitled International Symposia in Economic Theory and Econometrics. This conference was held in 1985 at the IC2 Institute at the University of Texas at Austin. The symposia in this series are sponsored by the IC2 Institute and the RGK Foundation. New Approaches to Monetary Economics, edited by Professors William A. Barnett and Kenneth J. Singleton, consists of five parts. Part I examines transactions-motivated monetary holding in general equilibrium; Part II, financial intermediation; Part III, monetary aggregation theory, Part IV, issues in aggregate fluctuation; and Part V, theoretical issues in the foundations of monetary economics and macroeconomics.
The seriousness of the Asian financial crises and difficulties in explaining its spread have led to fears of irrational contagion. This paper studies rational channels through which contagion might have spread and highlights those factors which make a country susceptible to contagion. The rational channels studied in the paper are contagion via real sector linkages, financial market linkages, financial institution linkages, and through the interaction of financial institutions and financial markets. The latter chan- nel is suggested as a possible factor in the reductions in financial market liquidity and the flight to quality following news of significant losses at the hedge fund Long Term Capital Management.
In the aftermath of the financial crisis, there is interest in reforming bank regulation such that capital requirements are more closely linked to a bank's contribution to the overall risk of the financial system. In our paper we compare alternative mechanisms for allocating the overall risk of a banking system to its member banks. Overall risk is estimated using a model that explicitly incorporates contagion externalities present in the financial system. We have access to a unique data set of the Canadian banking system, which includes individual banks' risk exposures as well as detailed information on interbank linkages including OTC derivatives. We find that systemic capital allocations can differ by as much as 50% from 2008Q2 capital levels and are not related in a simple way to bank size or individual bank default probability. Systemic capital allocation mechanisms reduce default probabilities of individual banks as well as the probability of a systemic crisis by about 25%. Our results suggest that financial stability can be enhanced substantially by implementing a systemic perspective on bank regulation.
What caused the crisis? Initially many thought that it was due to incentive problems in the U.S. mortgage industry. However, after the large economic meltdown following Lehman Brothers' bankruptcy in September 2008, it seems that much more was going on. We argue that there was a bubble in real estate prices in the United States and a number of other countries. The main causes of the bubble were loose monetary policy, particularly by the United States Federal Reserve, and global imbalances. The combination of cheap credit together with the easy availability of funds contributed to create the bubble. Many other factors such as subprime mortgages, weak regulatory structures, and high leverage in the banking sector exacerbated the effects of the crisis. We consider possible reforms aimed at minimizing the occurrence of future crises in the governance structure of central banks, measures to reduce global imbalances, and changes in banking regulation.
This paper empirically examines contagion effects of bank failures by analyzing the behavior of deposit flows in a sample of failed and healthy banks over the 1929–1933 period. We find evidence of contagion for 1930–1932, while none seems to have existed in 1929 or 1933. In addition, the pace of contagion accelerated over 1930–1932. We find that even during 1930–1932, failing-bank deposit outflows exceeded those at a matched control sample of nonfailing banks. This finding is consistent with the presence of a significant number of informed depositors who distinguished among ex ante failing and nonfailing banks.Journal of Economic LiteratureClassification Number: G21.
In this paper, we suggest an approach for measuring contagion across banks, and we outline preliminary results for the European banking sector. Information on contagion is crucial for authorities addressing risks to financial stability. Information on cross-border contagion, i.e., the extent to
Increasing inter-bank lending has an ambiguous impact on financial stability. Two opposing effects have been identified: promoting stability through risk sharing and providing a channel through which contagion may spread. In this paper we identify the conditions under which each relationship holds. In response to large economy-wide shocks, greater numbers of inter-bank lending relationships are shown to worsen systemic events, however, for smaller shocks the opposite effect is observed. As such there is no optimal inter-bank market structure which maximizes stability under all conditions. In contrast, deposit insurance costs are always reduced under greater numbers of inter-bank lending relationships.
Banking systems can easily be described by a network, where the links take the form of direct exposures between banks. The same connections that facilitate the transfer of liquidity between banks, expose the banking system to the risk of conta-gion. That is, idiosyncratic shocks, which initially a¤ect only a few institutions, may propagate through the entire system. This paper studies how the trade-o¤ between the bene…ts and the costs of being linked changes depending on the network struc-ture. We have shown that incomplete networks give rise to incomplete information. In this situation, the transfers between banks that perfectly ensures against liquidity shocks increase, at the same time, the contagion risk. The problem is solved when the network is complete, as the liquidity can be redistributed in the system, such that the risk of contagion is minimal.
In this paper we present a model of fire sales and market breakdowns, and of the financial amplification mechanism that follows from them. The distinctive feature of our model is the central role played by endogenous uncertainty. As conditions deteriorate, more “banks” within the financial network become distressed, which increases each (non-distressed) bank’s likelihood of being hit by an indirect shock. As this happens, banks face an increasingly complex environment since they need to understand more and more interlinkages in making their financial decisions. Uncertainty comes as a by-product of this complexity, and makes relatively healthy banks, and hence potential asset buyers, reluctant to buy. The liquidity of the market quickly vanishes and a financial crisis ensues. The model features a novel complexity externality which provides a rationale for various government policies commonly used during financial crises, including bailouts and asset price supports.
We develop a theory of optimal bank leverage in which the benefit of debt in inducing loan monitoring is balanced against
the benefit of equity in attenuating risk shifting. However, faced with socially costly correlated bank failures, regulators
bail out creditors. Anticipation of this generates multiple equilibria, including one with systemic risk in which banks use
excessive leverage to fund correlated, inefficiently risky loans. Limiting leverage and resolving both moral hazards—insufficient
loan monitoring and asset substitution—requires a novel two-tiered capital requirement, including a “special capital account”
that is unavailable to creditors upon failure. (JEL G21, G28, G32, G35, G38)
Received April 23, 2015; accepted September 16, 2015 by Editor Paolo Fulghieri.
This paper examines common regulation as cause of interbank contagion. Studies based on the correlation of bank assets and the extent of interbank lending may underestimate the likelihood of contagion because they do not incorporate the fact that banks have a common regulator. In our model, the failure of one bank can undermine the public’s confidence in the competence of the banking regulator, and hence in other banks chartered by the same regulator. Thus depositors may withdraw funds from other, unconnected, banks. The optimal regulatory response to this "panic" behaviour can be to privately exhibit forbearance to the initially failing bank in the hope that it - and hence other vulnerable banks - survives. By contrast, public bailouts are ineffective in preventing panics and must be bolstered by other measures such as increased deposit insurance coverage. Regulatory transparency improves confidence ex ante but impedes regulators’ ability to stem panics ex post.
We develop a measure of systemic importance that accounts for the extent to which a bank propagates shocks across the banking system and is vulnerable to propagated shocks. Based on Shapley values, this measure gauges the contribution of interconnected banks to systemic risk, in contrast to other measures proposed in the literature. An empirical implementation of our measure reveals that systemic importance depends materially on the bank's role in the interbank network, both as a borrower and as a lender. We also find substantial differences between alternative measures, which implies that prudential authorities should be careful in choosing the underlying approach.
We develop a model in which asset commonality and short-term debt of banks interact to generate excessive systemic risk. Banks swap assets to diversify their individual risk. Two asset structures arise. In a clustered structure, groups of banks hold common asset portfolios and default together. In an unclustered structure, defaults are more dispersed. Portfolio quality of individual banks is opaque but can be inferred by creditors from aggregate signals about bank solvency. When bank debt is short-term, creditors do not roll over in response to adverse signals and all banks are inefficiently liquidated. This information contagion is more likely under clustered asset structures. In contrast, when bank debt is long-term, welfare is the same under both asset structures.
Modern financial systems exhibit a high degree of interdependence. There are different possible sources of connections between financial 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 financial institutions. Broadly understood as a collection of nodes and links between nodes, networks can be a useful representation of financial systems. By providing means to model the specifics 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 financial systems. We review the recent developments in financial networks, highlighting the synergies created from applying network theory to answer financial questions. Further, we propose several directions of research. First, we consider the issue of systemic risk. In this context, two questions arise: how resilient financial networks are to contagion, and how financial 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 offerings, or seasoned debt and equity issues. Finally, we consider the role of networks as a form of mutual monitoring as in microfinance.
Financial contagion is modeled as an equilibrium phenomenon. Because liquidity preference shocks are imperfectly correlated across regions, banks hold interregional claims on other banks to provide insurance against liquidity preference shocks. When there is no aggregate uncertainty, the first-best allocation of risk sharing can be achieved. However, this arrangement is financially fragile. A small liquidity preference shock in one region can spread by contagion throughout the economy. The possibility of contagion depends strongly on the completeness of the structure of interregional claims. Complete claims structures are shown to be more robust than incomplete structures.
I model an entangled financial system in which banks hedge their portfolio risks using over-the-counter (OTC) contracts. However,
banks choose not to hedge counterparty risk, and thus the idiosyncratic failure of a bank can lead to a systemic run of lenders.
An inefficiency arises because banks engage in a version of risk shifting through the network externalities created by OTC
contracts. Banks do not take into account that the costly hedging of low-probability counterparty risk also benefits other
banks. In the model, it is welfare improving to tax OTC contracts to finance a bailout fund.
The 2008/9 financial crisis highlighted the importance of evaluating vulnerabilities owing to interconnectedness, or Too-Connected-to-Fail risk, among financial institutions for country monitoring, financial surveillance, investment analysis and risk management purposes. This paper illustrates the use of balance sheet-based network analysis to evaluate interconnectedness risk, under extreme adverse scenarios, in banking systems in mature and emerging market countries, and between individual banks in Chile, an advanced emerging market economy.
A complex financial system comprises both financial markets and financial intermediaries. We distinguish financial intermediaries according to whether they issue complete contingent contracts or incomplete contracts. Intermediaries such as banks that issue incomplete contracts, e.g., demand deposits, are subject to runs, but this does not imply a market failure. A sophisticated financial system—a system with complete markets for aggregate risk and limited market participation—is incentive-efficient, if the intermediaries issue complete contingent contracts, or else constrained-efficient, if they issue incomplete contracts. We argue that there may be a role for regulating liquidity provision in an economy in which markets for aggregate risks are incomplete.
Unique transaction-level data for nearly every federal funds transaction made during the first quarter of 1998 forms the foundation for this in-depth exploration of the federal funds market. Unlike previous studies that have relied on aggregate and typically infrequent measures of federal funds market participation, the transaction-level data exploited here allows a closer look at the microstructure of the market. The paper explores the relationship between bank size and participation in the funds market and discovers that even the largest banks are frequently net sellers of funds. A time-of-day pattern is uncovered, as is significant market concentration. Preliminary exploration into trading patterns, or networks, is conducted, and the existence of relationship lending in the interbank market is investigated.
What causes a financial crisis? Can financial crises be anticipated or even avoided? What can be done to lessen their impact? Should governments and international institutions intervene? Or should financial crises be left to run their course? In the aftermath of the Asian financial crisis, many blamed international institutions, corruption, governments, and flawed macro and microeconomic policies not only for causing the crisis but also unnecessarily lengthening and deepening it. Based on ten years of research, the authors develop a theoretical approach to analyzing financial crises. Beginning with a review of the history of financial crises and providing readers with the basic economic tools needed to understand the literature, the authors construct a series of increasingly sophisticated models. Throughout, the authors guide the reader through the existing theoretical and empirical literature while also building on their own theoretical approach. The text presents the modern theory of intermediation, introduces asset markets and the causes of asset price volatility, and discusses the interaction of banks and markets. The book also deals with more specialized topics, including optimal financial regulation, bubbles, and financial contagion.
This report analyses the impact of failures and weaknesses in corporate governance on the financial crisis, including risk management systems and executive salaries. It concludes that the financial crisis can be to an important extent attributed to failures and weaknesses in corporate governance arrangements which did not serve their purpose to safeguard against excessive risk taking in a number of financial services companies. Accounting standards and regulatory requirements have also proved insufficient in some areas. Last but not least, remuneration systems have in a number of cases not been closely related to the strategy and risk appetite of the company and its longer term interests. The article also suggests that the importance of qualified board oversight and robust risk management is not limited to financial institutions. The remuneration of boards and senior management also remains a highly controversial issue in many OECD countries. The current turmoil suggests a need for the OECD to re-examine the adequacy of its corporate governance principles in these key areas.
Under a real-time gross settlement (RTGS) system, there is an incentive for system participants to delay making their outgoing payments to facilitate their funding, and this creates the risk of settlement delays spreading throughout the entire system. Intraday credit facility and market practices have been established to avoid the risk and led to settlement concentration in the morning, as well as concentrations at the specific times due to other deferred net settlement (DNS) systems. The heterogeneity of intraday progress of settlements causes intraday fluctuation in interest rates. In this paper, we analyze and run simulations on the payment network to understand the intraday flow of funds within Japanfs interbank money market, especially recycling of the "receipt-driven payments." We find that (1) the shape of the payment network changes with the time of day, and payment recycling becomes more likely when the density of the network is high; (2) patterns of intraday payment flow differ across the three RTGS systems of the United States, the United Kingdom, and Japan, reflecting differences in each countryfs system for, and underlying approach to, settlement and funding; and (3) participants comprising the hub of the payment network function as absorbers of contagion under a condition sufficiently stressful to cause a cascade of settlement delays.
The global financial crisis has pinpointed the relevance and the virulence of systemic risk in modern innovative finance. It is grounded in the propensity of credit markets to drift to extremes in close correlation with asset price spikes and slumps. In turn, such a propensity is nurtured by the heuristic behaviour of market participants under severe uncertainty. While plagued by disaster myopia, market participants spread systemic risk. Such adverse conditions have been magnified by financial innovations that have made finance predatory and capable of capturing regulators to annihilate prudential policies. Malfunctioning in finance is so deep and disorders are so widespread that sweeping reforms are the order of the day, if financial stability is viewed as a primary public concern. In this paper we argue that macro prudential policy should be the linchpin of relevant reforms. Being a top-down approach, it impinges both upon monetary policy and micro prudential policy.
Financial crises have occurred for many centuries. They are often preceded by a credit boom and a rise in real estate and other asset prices, as in the current crisis. They are also often associated with severe disruption in the real economy. This paper surveys the theoretical and empirical literature on crises. The first explanation of banking crises is that they are a panic. The second is that they are part of the business cycle. Modeling crises as a global game allows the two to be unified. With all the liquidity problems in interbank markets that have occurred during the current crisis, there is a growing literature on this topic. Perhaps the most serious market failure associated with crises is contagion, and there are many papers on this important topic. The relationship between asset price bubbles, particularly in real estate, and crises is discussed at length.
We study interbank lending and asset sales markets in which banks with surplus liquidity have market power vis-a-vis banks needing liquidity, frictions arise in lending due to moral hazard, and assets are bank-specific. Surplus banks ration lending and instead purchase assets from needy banks, an inefficiency more acute during financial crises. A central bank acting as a lender-of-last-resort can ameliorate this inefficiency provided it is prepared to extend potentially loss-making loans or is better informed than outside markets, as might be the case if it also performs a supervisory role. This rationale for central banking finds support in historical episodes. (JEL E58, G01, G21, G28, L13, N21)