1,379 research outputs found
The effect of heterogeneity on financial contagion due to overlapping portfolios
We consider a model of financial contagion in a bipartite network of assets and banks recently introduced in the literature, and we study the effect of power law distributions of degree and balance-sheet size on the stability of the system. Relative to the benchmark case of banks with homogeneous degrees and balance-sheet sizes, we find that if banks have a power law degree distribution the system becomes less robust with respect to the initial failure of a random bank, and that targeted shocks to the most specialized banks (i.e., banks with low degrees) or biggest banks increases the probability of observing a cascade of defaults. In contrast, we find that a power law degree distribution for assets increases stability with respect to random shocks, but not with respect to targeted shocks. We also study how allocations of capital buffers between banks affects the system’s stability, and we find that assigning capital to banks in relation to their level of diversification reduces the probability of observing cascades of defaults relative to size-based allocations. Finally, we propose a non-capital-based policy that improves the resilience of the system by introducing disassortative mixing between banks and assets
Statistically validated network of portfolio overlaps and systemic risk
Common asset holding by financial institutions, namely portfolio overlap, is
nowadays regarded as an important channel for financial contagion with the
potential to trigger fire sales and thus severe losses at the systemic level.
In this paper we propose a method to assess the statistical significance of the
overlap between pairs of heterogeneously diversified portfolios, which then
allows us to build a validated network of financial institutions where links
indicate potential contagion channels due to realized portfolio overlaps. The
method is implemented on a historical database of institutional holdings
ranging from 1999 to the end of 2013, but can be in general applied to any
bipartite network where the presence of similar sets of neighbors is of
interest. We find that the proportion of validated network links (i.e., of
statistically significant overlaps) increased steadily before the 2007-2008
global financial crisis and reached a maximum when the crisis occurred. We
argue that the nature of this measure implies that systemic risk from fire
sales liquidation was maximal at that time. After a sharp drop in 2008,
systemic risk resumed its growth in 2009, with a notable acceleration in 2013,
reaching levels not seen since 2007. We finally show that market trends tend to
be amplified in the portfolios identified by the algorithm, such that it is
possible to have an informative signal about financial institutions that are
about to suffer (enjoy) the most significant losses (gains)
Stability analysis of financial contagion due to overlapping portfolios
Common asset holdings are widely believed to have been the primary vector of
contagion in the recent financial crisis. We develop a network approach to the
amplification of financial contagion due to the combination of overlapping
portfolios and leverage, and we show how it can be understood in terms of a
generalized branching process. By studying a stylized model we estimate the
circumstances under which systemic instabilities are likely to occur as a
function of parameters such as leverage, market crowding, diversification, and
market impact. Although diversification may be good for individual
institutions, it can create dangerous systemic effects, and as a result
financial contagion gets worse with too much diversification. Under our model
there is a critical threshold for leverage; below it financial networks are
always stable, and above it the unstable region grows as leverage increases.
The financial system exhibits "robust yet fragile" behavior, with regions of
the parameter space where contagion is rare but catastrophic whenever it
occurs. Our model and methods of analysis can be calibrated to real data and
provide simple yet powerful tools for macroprudential stress testing.Comment: 25 pages, 8 figure
Credit Risk Meets Random Matrices: Coping with Non-Stationary Asset Correlations
We review recent progress in modeling credit risk for correlated assets. We
start from the Merton model which default events and losses are derived from
the asset values at maturity. To estimate the time development of the asset
values, the stock prices are used whose correlations have a strong impact on
the loss distribution, particularly on its tails. These correlations are
non-stationary which also influences the tails. We account for the asset
fluctuations by averaging over an ensemble of random matrices that models the
truly existing set of measured correlation matrices. As a most welcome side
effect, this approach drastically reduces the parameter dependence of the loss
distribution, allowing us to obtain very explicit results which show
quantitatively that the heavy tails prevail over diversification benefits even
for small correlations. We calibrate our random matrix model with market data
and show how it is capable of grasping different market situations.
Furthermore, we present numerical simulations for concurrent portfolio risks,
i.e., for the joint probability densities of losses for two portfolios. For the
convenience of the reader, we give an introduction to the Wishart random matrix
model.Comment: Review of a new random matrix approach to credit ris
Contagion in an interacting economy
We investigate the credit risk model defined in Hatchett & K\"{u}hn under
more general assumptions, in particular using a general degree distribution for
sparse graphs. Expanding upon earlier results, we show that the model is
exactly solvable in the limit and demonstrate that the
exact solution is described by the message-passing approach outlined by Karrer
and Newman, generalized to include heterogeneous agents and couplings. We
provide comparisons with simulations of graph ensembles with power-law degree
distributions.Comment: 21 pages, 6 figure
DebtRank: A microscopic foundation for shock propagation
The DebtRank algorithm has been increasingly investigated as a method to
estimate the impact of shocks in financial networks, as it overcomes the
limitations of the traditional default-cascade approaches. Here we formulate a
dynamical "microscopic" theory of instability for financial networks by
iterating balance sheet identities of individual banks and by assuming a simple
rule for the transfer of shocks from borrowers to lenders. By doing so, we
generalise the DebtRank formulation, both providing an interpretation of the
effective dynamics in terms of basic accounting principles and preventing the
underestimation of losses on certain network topologies. Depending on the
structure of the interbank leverage matrix the dynamics is either stable, in
which case the asymptotic state can be computed analytically, or unstable,
meaning that at least one bank will default. We apply this framework to a
dataset of the top listed European banks in the period 2008 - 2013. We find
that network effects can generate an amplification of exogenous shocks of a
factor ranging between three (in normal periods) and six (during the crisis)
when we stress the system with a 0.5% shock on external (i.e. non-interbank)
assets for all banks.Comment: 10 pages, 2 figure
Mapping systemic risk: critical degree and failures distribution in financial networks
The 2008 financial crisis illustrated the need for a thorough, functional
understanding of systemic risk in strongly interconnected financial structures.
Dynamic processes on complex networks being intrinsically difficult, most
recent studies of this problem have relied on numerical simulations. Here we
report analytical results in a network model of interbank lending based on
directly relevant financial parameters, such as interest rates and leverage
ratios. Using a mean-field approach, we obtain a closed-form formula for the
"critical degree", viz. the number of creditors per bank below which an
individual shock can propagate throughout the network. We relate the failures
distribution (probability that a single shock induces failures) to the
degree distribution (probability that a bank has creditors), showing in
particular that the former is fat-tailed whenever the latter is. Our criterion
for the onset of contagion turns out to be isomorphic to the condition for
cooperation to evolve on graphs and social networks, as recently formulated in
evolutionary game theory. This remarkable connection supports recent calls for
a methodological rapprochement between finance and ecology.Comment: 19 pages, 4 figure
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