OFRwp0009_GlassermanYoung_HowLikelyContagionFinancialNetworks

3 quality of particular rms if a rms perceived

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Unformatted text preview: o be of greater importance is crises of confidence in the credit 3 See Shleifer and Vishny (2011) for a survey and Cifuentes, Ferrucci, and Shin (2005) for an extension of the EisenbergNoe framework with fire sales. 3 quality of particular firms. If a firm’s perceived ability to pay declines for whatever reason, then so does the market value of its liabilities. In a mark-to-market regime this reduction in value can spread to other firms that hold these liabilities among their assets. In other words, the mere possibility (rather than the actuality) of a default can lead to a general and widespread decline in valuations, which may in turn trigger actual defaults through mark-to-market losses.4 This is an important phenomenon in practice: indeed it has been estimated that mark-to-market losses from credit quality deterioration exceeded losses from outright defaults in 2007-2009.5 We capture this idea by re-interpreting the Eisenberg-Noe framework as a valuation model rather than as a clearing model. Declines in confidence about the ability to pay at some nodes can spread to other nodes through a downward revaluation of their assets. This mechanism shows how a localized crisis of confidence can lead to widespread losses of value. Our analysis suggests that this channel of contagion is likely to be considerably more important than simple domino or spillover effects. The rest of the paper is organized as follows. In Section 2 we present the basic Eisenberg-Noe framework and illustrate its operation through a series of simple examples. In Section 3 we introduce shock distributions explicitly. We then compare the probability that a given set of nodes default from simultaneous direct shocks to their outside assets, with the probability that they default indirectly by contagion from some other node. In Section 4 we examine the expected loss in value that is attributable to network contagion using the comparative framework described above. We show that one can obtain useful bounds on the losses attributable to the network with almost no knowledge of the specific network topology and under very general assumptions about the shock distributions. In Section 5 we introduce bankruptcy costs and show how to extend the preceding analysis to this case. Section 6 examines the effects of a deterioration in confidence at one or more institutions, such as occurred in the 2008-09 financial crisis. We show how such a loss of confidence can spread through the entire system due to mark-to-market declines in asset values. In the Appendix we illustrate the application of these ideas to the European banking system using data from European Banking Authority (2011). 2 2.1 Measuring systemic risk The Eisenberg-Noe framework The network model proposed by Eisenberg and Noe (2001) has three basic ingredients: a set of n nodes ¯ N = {1, 2, ..., n}, an n × n liabilities matrix P = (¯ij ) where pij ≥ 0 represents the payment due from p ¯ 4 This mechanism differs from a bank run, which could also be triggered by a loss of confid...
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This document was uploaded on 02/20/2014 for the course ECON 101 at Pontificia Universidad Católica de Chile.

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