Size and complexity in model financial systems

The global financial crisis has precipitated an increasing appreciation of the need for a systemic perspective toward financial stability. For example: What role do large banks play in systemic risk? How should capital adequacy standards recognize this role? How is stability shaped by concentration and diversification in the financial system? We explore these questions using a deliberately simplified, dynamic model of a banking system that combines three different channels for direct transmission of contagion from one bank to another: liquidity hoarding, asset price contagion, and the propagation of defaults via counterparty credit risk. Importantly, we also introduce a mechanism for capturing how swings in “confidence” in the system may contribute to instability. Our results highlight that the importance of relatively large, well-connected banks in system stability scales more than proportionately with their size: the impact of their collapse arises not only from their connectivity, but also from their effect on confidence in the system. Imposing tougher capital requirements on larger banks than smaller ones can thus enhance the resilience of the system. Moreover, these effects are more pronounced in more concentrated systems, and continue to apply, even when allowing for potential diversification benefits that may be realized by larger banks. We discuss some tentative implications for policy, as well as conceptual analogies in ecosystem stability and in the control of infectious diseases.

[1]  Wolf Wagner,et al.  Systemic Liquidation Risk and the DiversityDiversification Trade-Off , 2011 .

[2]  M. Marsili,et al.  Epidemics of Rules, Information Aggregation Failure and Market Crashes , 2010 .

[3]  R. May,et al.  Infectious Diseases of Humans: Dynamics and Control , 1991, Annals of Internal Medicine.

[4]  H. Shin,et al.  Liquidity Risk and Contagion , 2005 .

[5]  A Model of Liquidity Hoarding and Term Premia in Inter-Bank Markets , 2011 .

[6]  S. Battiston,et al.  Liaisons Dangereuses: Increasing Connectivity, Risk Sharing, and Systemic Risk , 2009 .

[7]  H. Shin,et al.  Monetary Aggregates and the Central Bank’s Financial Stability Mandate , 2013 .

[8]  Prasanna Gai,et al.  Complexity, concentration and contagion , 2011 .

[9]  D. Scharfstein,et al.  Bank Lending During the Financial Crisis of 2008 , 2009 .

[10]  P. E. Kopp,et al.  Superspreading and the effect of individual variation on disease emergence , 2005, Nature.

[11]  S. Strogatz Exploring complex networks , 2001, Nature.

[12]  H. Shin,et al.  Liquidity and Leverage , 2009 .

[13]  Prasanna Gai,et al.  Contagion in financial networks , 2010, Proceedings of the Royal Society A: Mathematical, Physical and Engineering Sciences.

[14]  P. Courant,et al.  What Are Grades Made Of? , 2009, The journal of economic perspectives : a journal of the American Economic Association.

[15]  Matteo Marsili,et al.  Eroding market stability by proliferation of financial instruments , 2009 .

[16]  Jing Yang,et al.  Network Models and Financial Stability , 2007 .

[17]  George Sugihara,et al.  Complex systems: Ecology for bankers , 2008, Nature.

[18]  Gary B. Gorton,et al.  Securitized Banking and the Run on Repo , 2009 .

[19]  R. May,et al.  Systemic risk: the dynamics of model banking systems , 2010, Journal of The Royal Society Interface.

[20]  Markus K. Brunnermeier,et al.  Market Liquidity and Funding Liquidity , 2005 .

[21]  Franklin Allen,et al.  Networks in Finance , 2008 .

[22]  J. Yang,et al.  Network Models and Financial Stability , 2008 .

[23]  Walter E. Beyeler,et al.  The topology of interbank payment flows , 2007 .

[24]  R. May,et al.  Systemic risk in banking ecosystems , 2011, Nature.

[25]  V. Acharya,et al.  A model of liquidity hoarding and term premia in inter-bank markets , 2011 .

[26]  A. Kirman Complex Economics: Individual and Collective Rationality , 2010 .

[27]  Joseph G. Haubrich,et al.  Quantifying Systemic Risk , 2013 .

[28]  Ricardo J. Caballero,et al.  Collective Risk Management in a Flight to Quality Episode , 2007 .

[29]  Mathias Drehmann,et al.  Systemic Importance: Some Simple Indicators , 2011 .

[30]  Joshua D. Coval,et al.  Asset Fire Sales (and Purchases) in Equity Markets , 2005 .

[31]  Markus K. Brunnermeier Deciphering the Liquidity and Credit Crunch 2007-08 , 2008 .

[32]  Mathias Drehmann,et al.  Liquidity Risk, Cash-Flow Constraints and Systemic Feedbacks , 2012 .

[33]  Michael Boss,et al.  Network topology of the interbank market , 2003, cond-mat/0309582.

[34]  Christian Upper,et al.  Simulation methods to assess the danger of contagion in interbank markets , 2011 .

[35]  S. Levin,et al.  The Importance of Species: Perspectives on Expendability and Triage , 2003 .

[36]  R. Paine Food Web Complexity and Species Diversity , 1966, The American Naturalist.

[37]  Markus K. Brunnermeier Deciphering the 2007-08 Liquidity and Credit Crunch , 2008 .