Abstract
This paper introduces a novel framework to study default dependence and systemic risk in a financial network that evolves over time. We analyse several indicators of risk, and develop a new latent space model to assess the health of key European banks before, during and after the recent financial crises. We propose a new statistical model that permits a latent space visualisation of the financial system. This provides a clear and interpretable model-based summary of the interaction data, and it gives a new perspective on the topology structure of the network. Crucially, the methodology provides a new approach to assess and understand the systemic risk associated with a financial system, and to study how debt may spread between institutions. Our dynamic framework provides an interpretable map that illustrates the default dependencies between institutions, highlighting the possible patterns of contagion and the institutions that may pose systemic threats.
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Notes
These are the extreme values observed across all time frames.
Results available upon request.
Results are available upon request.
Results are available upon request.
LogLoss function computes cross-entropy loss between forecasting and true values of out-of-sample. It is available in R package MLmetrics (Yan 2016).
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Appendices
Appendices
Appendix A: Proof of Proposition 1
Proof
We wish to study the density \(\pi \left( y_i^{(t)} \big | \mathbf{y }_{-(i,t)}, \mathbf{Z }, \mathbf{X } \right) \), up to a proportionality constant that does not depend on \(y_i^{(t)}\):
where
Then:
which is proportional to a Gaussian density with the following mean and variance:
\(\square \)
Appendix B: Summary of default probabilities by bank
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Tafakori, L., Pourkhanali, A. & Rastelli, R. Measuring systemic risk and contagion in the European financial network. Empir Econ 63, 345–389 (2022). https://doi.org/10.1007/s00181-021-02135-y
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DOI: https://doi.org/10.1007/s00181-021-02135-y