OFRwp0009_GlassermanYoung_HowLikelyContagionFinancialNetworks

OFRwp0009_GlassermanYoung_HowLikelyContagionFinancialNetworks

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How Likely is Contagion in Financial Networks? Paul Glasserman * and H. Peyton Young Abstract Interconnections among fnancial institutions create potential channels For contagion and amplifca- tion oF shocks to the fnancial 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 magnifed by some mechanism beyond simple spillover effects; these include bankruptcy costs, fre sales, and mark-to-market revaluations oF assets. We illustrate the results with data on the European banking system. Keywords: systemic risk, contagion, fnancial 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 Fnancial system is widely viewed as having been a key contributing factor to the recent Fnancial 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 Fnancial stability. SpeciFc 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 highlight concerns that interconnectedness could pose a signiFcant threat to the stability of the Fnancial system. 1 Moreover there is a growing body of research that shows how this can happen in a theoretical sense. 2 Although it is intuitively clear that interconnectedness has some effect on the transmission of shocks, it is less clear whether and how it signiFcantly increases the likelihood and magnitude of losses compared to a Fnancial system that is not interconnected. In this paper we propose a general framework for analyzing this question. There are in fact many different types of networks connecting parts of the Fnancial system, including networks deFned through ownership hierarchies, payment systems, derivatives contracts, brokerage relationships, and correlations in stock prices, among other examples. We focus on the network deFned by liabilities between Fnancial institutions. These payment obligations create the most direct channel for the spread of losses.
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OFRwp0009_GlassermanYoung_HowLikelyContagionFinancialNetworks

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