The impact of network inhomogeneities on contagion and system stability
- 169 Downloads
This work extends the contagion model introduced by Nier et al. (J Econ Dyn Control 31(6):2033–2060, 2007. http://www.bankofengland.co.uk/publications/workingpapers/wp346.pdf) to inhomogeneous networks. We preserve the convenient description of a financial system using a sparsely parameterized random graph, but add several relevant inhomogeneities. These include well-connected banks, financial institutions with disproportionately large interbank assets, and big banks that focus on wholesale and retail customers. These extensions significantly enhance the model’s generality as they reflect realistic inhomogeneities that have a potentially decisive impact on a system’s stability. We find that large and well-connected banks have a surprisingly modest impact. However, institutions with disproportionately large interbank assets significantly increase the risk of contagion in networks. Moreover, these effects can be partly compensated by a redistribution of equity capital, even without increasing the total amount. However, the level of regulatory capital should be defined according to the interbank market position of a bank, and not the size of the bank.
KeywordsBanking system Capital buffers Contagion Contagious defaults Inhomogeneities Network models Financial system stability Systemic risk
- Aikman, D., Alessandri, P., Eklund, B., Gai, P., Kapadia, S., Martin, E., et al. (2009). Funding liquidity risk in a quantitative model of systemic stability. Bank of England Working Paper 372.Google Scholar
- Allen, F., & Babus, A. (2009). Networks in finance. In P. Kleindorfer, J. Wind, & R. E. Gunther (Eds.), The network challenge. Upper Saddle River: Wharton School Publishing.Google Scholar
- Anand, K., Gai, P., Kapadia, S., Brennan, S., & Willison, M. (2012). A network model of financial system resilience. Bank of England Working Paper No. 458.Google Scholar
- Berman, P., DasGupta, B., Kaligounder, L., & Kerpinski, M. (2011). On vulnerability of banking networks. arXiv:1110.3546v2 [q-finRM]
- Caccioli, F., Catanach, T. A., & Farmer, J. D. (2012). Heterogeneity, correlations and financial contagion. Advances in Complex Systems, 15(supp02), 1250058.Google Scholar
- Cihák, M., Muñoz, S., & Scuzzarella, R. (2011). The bright and the dark side of cross-border banking linkages. IMF Working Papers WP/11/186.Google Scholar
- Cont, R., Moussa, A., & Santos, E. B. (2012). Network structure and systemic risk in banking systems. Working Paper Columbia Center for Financial Engineering.Google Scholar
- Erdös, P., & Rényi, A. (1959). On random graphs, I. Publicationes Mathematicae (Debrecen), 6, 290–297. http://www.renyi.hu/~p_erdos/Erdos.html#1959-11.
- European Central Bank. (2010a). Analytical models and tools for the identification and assessment of systemic risks. Financial Stability Review, 38–46.Google Scholar
- European Central Bank. (2010b). Financial networks and financial stability. Financial Stability Review, 155–160.Google Scholar
- Freixas, X., Parigi, B. M., & Rochet, J. C. (2000). Systemic risk, interbank relations, and liquidity provision by the central bank. In Proceedings (pp. 611–640). http://ideas.repec.org/a/fip/fedcpr/y2000p611-640.html.
- Hale, G. (2012). Bank relationships, business cycles, and financial crises. Journal of International Economics, 117, 196–215. http://www.frbsf.org/publications/economics/papers/2011/wp11-14bk.pdf.
- Nier, E., Yang, J., Yorulmazer, T., & Alentorn, A. (2007). Network models and financial stability. Journal of Economic Dynamics and Control 31(6), 2033–2060. http://www.bankofengland.co.uk/publications/workingpapers/wp346.pdf.
- Tasca, P., & Battiston, S. (2014). Diversification and financial stability. London School of Economics, SRC Discussion Paper No. 10.Google Scholar
- Upper, C. (2007). Using counterfactual simulations to assess the danger of contagion in interbank markets. BIS Working Papers 234.Google Scholar
- Watts, D. J. (2002). A simple model of global cascades on random networks. Proceedings of the National Academy of Sciences of the United States of America, 99(9), 5766–5771. http://www.jstor.org/stable/3058573.