Towards a Proper Assignment of Systemic Risk: The Combined Roles of Network Topology and Shock Characteristics

Abstract

The 2007-2008 financial crisis solidified the consensus among policymakers that a macro-prudential approach to regulation and supervision should be adopted. The currently preferred policy option is the regulation of capital requirements, with the main focus on combating procyclicality and on identifying the banks that have a high systemic importance, those that are “too big to fail”. Here we argue that the concept of systemic risk should include the analysis of the system as a whole and we explore systematically the most important properties for policy purposes of networks topology on resistance to shocks. In a thorough study going from analytical models to empirical data, we show two sharp transitions from safe to risky regimes: 1) diversification becomes harmful with just a small fraction (~2%) of the shocks sampled from a fat tailed shock distributions and 2) when large shocks are present a critical link density exists where an effective giant cluster forms and most firms become vulnerable. This threshold depends on the network topology, especially on modularity. Firm size heterogeneity has important but diverse effects that are heavily dependent on shock characteristics. Similarly, degree heterogeneity increases vulnerability only when shocks are directed at the most connected firms. Furthermore, by studying the structure of the core of the transnational corporation network from real data, we show that its stability could be clearly increased by removing some of the links with highest centrality betweeness. Our results provide a novel insight and arguments for policy makers to focus surveillance on the connections between firms, in addition to capital requirements directed at the nodes.

Systemic Risk, Contagion, and Financial Networks: A Survey

“…Lastly, Loepfe et al (2013) show how heterogeneity in the size of the shocks, in the size of agents and in the level of connectivity can affect the stability of the financial system and how a macro-prudential approach to regulation can be used to control systemic risk. The model is described as follows: there exist N risk-neutral financial firms (i.e.…”

“…In their numerical simulations, the authors use a modified version of the preferential attachment model to generate networks with given characteristics in terms of the level of modularity and degree heterogeneity. From a numerical standpoint, Loepfe et al (2013) show that: the level of capital is the most important parameter in determining the stability of the financial system; when attacks are targeted to the too-big-to-fail banks, having high size heterogeneity is detrimental to the stability of the system; the same principle applies when the attacks target the too-connected-to-fail nodes and the heterogeneity regards the level of connectivity of the banks. Non-linearities exist in the way in which different parameters of the models interact.…”

Ecological Econophysics for Degrowth

“…Its scale-invariant granularity has a strong incidence on macroeconomic fluctuations, as shown in [123]. Its modularity (i.e., the tendency for interacting "grains" to be grouped in clusters) also seems to play a major role [112]. Therefore, it is plausible that economies respond to environmental pressures by increasing the intensity of recessions in a way similar to the model.…”

“…The author warned in 2003 that, due to the quick process of globalization, "there is a fast generation of long-range connections of all kinds, and we cannot rule out that these make the system become 'supercritical' " and added that this and other concerns "made it irresponsible a fast process of globalization not preceded by a serious analysis of the consequences" ( [31], p. 351). Now, there is evidence that the stability of the world economy was compromised by the quick increase in international connections among banks up to 2008 [112]. The financial crisis might have caused a collapse of the global economy if governments had not intervened.…”

“…Had the crisis taken place later, it could have resulted in collapse even with governments intervening. Similarly to fires removing fuel, the amount of connections dropped sharply with the crisis [112,119]. Subsequently, however, governments have gone ahead with new agreements to force a quick globalization.…”