DebtRank-transparency: Controlling systemic risk in financial networks

TL;DR

This paper proposes a transparency-based regulation scheme using DebtRank metrics to reduce systemic risk in financial networks by encouraging risk-homogeneous lending and minimizing cascading failures.

Contribution

It introduces a simple incentive mechanism leveraging DebtRank transparency to effectively control systemic risk without compromising network efficiency.

Findings

Systemic risk is significantly reduced with increased DebtRank transparency.

Cascading failures are drastically decreased in the transparent system.

The regulation scheme promotes a more homogeneous risk distribution.

Abstract

Banks in the interbank network can not assess the true risks associated with lending to other banks in the network, unless they have full information on the riskiness of all the other banks. These risks can be estimated by using network metrics (for example DebtRank) of the interbank liability network which is available to Central Banks. With a simple agent based model we show that by increasing transparency by making the DebtRank of individual nodes (banks) visible to all nodes, and by imposing a simple incentive scheme, that reduces interbank borrowing from systemically risky nodes, the systemic risk in the financial network can be drastically reduced. This incentive scheme is an effective regulation mechanism, that does not reduce the efficiency of the financial network, but fosters a more homogeneous distribution of risk within the system in a self-organized critical way. We show that the reduction of systemic risk is to a large extent due to the massive reduction of cascading failures in the transparent system. An implementation of this minimal regulation scheme in real financial networks should be feasible from a technical point of view.