Systemic losses in banking networks: indirect interaction of nodes via asset prices

We report a study of a stylized banking cascade model investigating systemic risk caused by counter party failure using liabilities and assets to define banks' balance sheet. In our stylized system, banks can be in two states: normally operating or distressed and the state of a bank changes from normally operating to distressed whenever its liabilities are larger than the banks' assets. The banks are connected through an interbank lending network and, whenever a bank is distr...

This systemic risk paper introduces inhomogeneous random financial networks (IRFNs). Such models are intended to describe parts, or the entirety, of a highly heterogeneous network of banks and their interconnections, in the global financial system. Both the balance sheets and the stylized crisis behaviour of banks are ingredients of the network model. A systemic crisis is pictured as triggered by a shock to banks' balance sheets, which then leads to the propagation of damagin...

The scope of financial systemic risk research encompasses a wide range of interbank channels and effects, including asset correlation shocks, default contagion, illiquidity contagion, and asset fire sales. This paper introduces a financial network model that combines the default and liquidity stress mechanisms into a "double cascade mapping". The progress and eventual result of the crisis is obtained by iterating this mapping to its fixed point. Unlike simpler models, this mo...

Propagation of balance-sheet or cash-flow insolvency across financial institutions may be modeled as a cascade process on a network representing their mutual exposures. We derive rigorous asymptotic results for the magnitude of contagion in a large financial network and give an analytical expression for the asymptotic fraction of defaults, in terms of network characteristics. Our results extend previous studies on contagion in random graphs to inhomogeneous directed graphs wi...

We introduce a probabilistic framework that represents stylized banking networks with the aim of predicting the size of contagion events. Most previous work on random financial networks assumes independent connections between banks, whereas our framework explicitly allows for (dis)assortative edge probabilities (e.g., a tendency for small banks to link to large banks). We analyze default cascades triggered by shocking the network and find that the cascade can be understood as...

In this paper we analyze the resilience of a network of banks to joint price fluctuations of the external assets in which they have shared exposures, and evaluate the worst-case effects of the possible default contagion. Indeed, when the prices of certain external assets either decrease or increase, all banks exposed to them experience varying degrees of simultaneous shocks to their balance sheets. These coordinated and structured shocks have the potential to exacerbate the l...

Systemic risk in banking systems remains a crucial issue that it has not been completely understood. In our toy model, banks are exposed to two sources of risks, namely, market risk from their investments in assets external to the banking system and credit risk from their lending in the interbank market. By and large, both risks increase during severe financial turmoil. Under this scenario, the paper shows the conditions under which both the individual and the systemic defaul...

A probabilistic framework is introduced that represents stylized banking networks and aims to predict the size of contagion events. In contrast to previous work on random financial networks, which assumes independent connections between banks, the possibility of disassortative edge probabilities (an above average tendency for small banks to link to large banks) is explicitly incorporated. We give a probabilistic analysis of the default cascade triggered by shocking the networ...

The interconnectedness of financial institutions affects instability and credit crises. To quantify systemic risk we introduce here the PD model, a dynamic model that combines credit risk techniques with a contagion mechanism on the network of exposures among banks. A potential loss distribution is obtained through a multi-period Monte Carlo simulation that considers the probability of default (PD) of the banks and their tendency of defaulting in the same time interval. A con...

I show the equivalence between a model of financial contagion and the threshold model of global cascades proposed by Watts (2002). The model financial network comprises banks that hold risky external assets as well as interbank assets. It is shown that a simple threshold model can replicate the size and the frequency of financial contagion without using information about individual balance sheets. Keywords: financial network, cascades, financial contagion, systemic risk.