Impact of Contingent Payments on Systemic Risk in Financial Networks

We undertake a fundamental study of network equilibria modeled as solutions of fixed point equations for monotone linear functions with saturation nonlinearities. The considered model extends one originally proposed to study systemic risk in networks of financial institutions interconnected by mutual obligations and is one of the simplest continuous models accounting for shock propagation phenomena and cascading failure effects. It also characterizes Nash equilibria of constr...

We quantify the sensitivity of the Eisenberg-Noe clearing vector to estimation errors in the bilateral liabilities of a financial system in a stylized setting. The interbank liabilities matrix is a crucial input to the computation of the clearing vector. However, in practice central bankers and regulators must often estimate this matrix because complete information on bilateral liabilities is rarely available. As a result, the clearing vector may suffer from estimation errors...

In this work we provide a simple setting that connects the structural modelling approach of Gai-Kapadia interbank networks with the mean-field approach to default contagion. To accomplish this we make two key contributions. First, we propose a dynamic default contagion model with endogenous early defaults for a finite set of banks, generalising the Gai-Kapadia framework. Second, we reformulate this system as a stochastic particle system leading to a limiting mean-field proble...

The aim of this paper is to quantify and manage systemic risk caused by default contagion in the interbank market. We model the market as a random directed network, where the vertices represent financial institutions and the weighted edges monetary exposures between them. Our model captures the strong degree of heterogeneity observed in empirical data and the parameters can easily be fitted to real data sets. One of our main results allows us to determine the impact of local ...

Financial networks help firms manage risk but also enable financial shocks to spread. Despite their importance, existing models of financial networks have several limitations. Prior works often consider a static network with a simple structure (e.g., a ring) or a model that assumes conditional independence between edges. We propose a new model where the network emerges from interactions between heterogeneous utility-maximizing firms. Edges correspond to contract agreements be...

Based on an empirical analysis of the network structure of the Austrian inter-bank market, we study the flow of funds through the banking network following exogenous shocks to the system. These shocks are implemented by stochastic changes in variables like interest rates, exchange rates, etc. We demonstrate that the system is relatively stable in the sence that defaults of individual banks are unlikely to spread over the entire network. We study the contagion impact of all in...

In this paper, we propose a dynamical model to capture cascading failures among interconnected organizations in the global financial system. Failures can take the form of bankruptcies, defaults, and other insolvencies. The network that underpins the financial interdependencies between different organizations constitutes the backbone of the financial system. A failure in one or more of these organizations can lead the propagation of the financial collapse onto other organizati...

We study the role of contingent convertible bonds (CoCos) in a complex network of interconnected banks. By studying the system's phase transitions, we reveal that the structure of the interbank network is of fundamental importance for the effectiveness of CoCos as a financial stability enhancing mechanism. Our results show that, under some network structures, the presence of CoCos can increase (and not reduce) financial fragility, because of the occurring of unneeded triggers...

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 ...

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.