OFRwp0009_GlassermanYoung_HowLikelyContagionFinancialNetworks

OFRwp0009_GlassermanYoung_HowLikelyContagionFinancialNetworks

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O FFICE OF F INANCIAL R ESEARCH U.S. D EPARTMENT OF THE T REASURY Office of Financial Research Working Paper #0009 June 21, 2013 How Likely is Contagion in Financial Networks? Paul Glasserman, 1 and H. Peyton Young 2 1 Columbia Business School, Columbia University [email protected] 2 Department of Economics, University of Oxford, and Office of Financial Research, U.S. Department of Treasury, [email protected] The Office of Financial Research (OFR) Working Paper Series allows staff and their co-authors to disseminate preliminary research findings in a format intended to generate discussion and critical comments. Papers in the OFR Working Paper Series are works in progress and subject to revision. Views and opinions expressed are those of the authors and do not necessarily represent official OFR or Treasury positions or policy. Comments are welcome as are suggestions for improvements, and should be directed to the authors. OFR Working Papers may be quoted without additional permission. www.treasury.gov/ofr
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How Likely is Contagion in Financial Networks? Paul Glasserman * and H. Peyton Young Abstract Interconnections among financial institutions create potential channels for contagion and amplifica- tion of shocks to the financial system. We estimate the extent to which interconnections increase expected losses, with minimal information about network topology, under a wide range of shock distributions. Expected losses from network effects are small without substantial heterogeneity in bank sizes and a high degree of reliance on interbank funding. They are also small unless shocks are magnified by some mechanism beyond simple spillover effects; these include bankruptcy costs, fire sales, and mark-to-market revaluations of assets. We illustrate the results with data on the European banking system. Keywords: systemic risk, contagion, financial network JEL: D85, G21 We thank Thomas Noe and Alireza Tahbaz-Salehi for constructive comments on an earlier draft. The views and opinions expressed are those of the authors and do not necessarily represent official OFR or Treasury positions or policy. Comments are welcome as are suggestions for improvements and should be directed to the authors. OFR Working Papers may be quoted without additional permission. * Columbia Business School, Columbia University, [email protected] Department of Economics, University of Oxford, and Office of Financial Research, U.S. Treasury, pey- [email protected]
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1 Introduction The interconnectedness of the modern financial system is widely viewed as having been a key contributing factor to the recent financial crisis. Due to the complex web of links between institutions, stresses to one part of the system can spread to others, leading to a system-wide threat to financial stability. Specific instances include the knock-on effects of the Lehman bankruptcy, potential losses to counterparties that would have resulted from a failure of the insurance company AIG, and more recently the exposure of European banks to the risk of sovereign default by some European countries. These and other examples
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