271 research outputs found
On information efficiency and financial stability
We study a simple model of an asset market with informed and non-informed
agents. In the absence of non-informed agents, the market becomes information
efficient when the number of traders with different private information is
large enough. Upon introducing non-informed agents, we find that the latter
contribute significantly to the trading activity if and only if the market is
(nearly) information efficient. This suggests that information efficiency might
be a necessary condition for bubble phenomena, induced by the behavior of
non-informed traders, or conversely that throwing some sands in the gears of
financial markets may curb the occurrence of bubbles.Comment: 14 pages, 2 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
A proposal for impact-adjusted valuation: Critical leverage and execution risk
The practice of valuation by marking-to-market with current trading prices is
seriously flawed. Under leverage the problem is particularly dramatic: due to
the concave form of market impact, selling always initially causes the expected
leverage to increase. There is a critical leverage above which it is impossible
to exit a portfolio without leverage going to infinity and bankruptcy becoming
likely. Standard risk-management methods give no warning of this problem, which
easily occurs for aggressively leveraged positions in illiquid markets. We
propose an alternative accounting procedure based on the estimated market
impact of liquidation that removes the illusion of profit. This should curb the
leverage cycle and contribute to an enhanced stability of financial markets.Comment: 19 pages, 3 figure
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
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