Early-warning signals of topological collapse in interbank networks

TL;DR

This paper investigates how topological changes in interbank networks can serve as early-warning signals for systemic crises, highlighting the importance of detailed network data for accurate risk assessment.

Contribution

It introduces a method to detect early-warning signals of financial crises through topological analysis of interbank networks, emphasizing the role of complete data.

Findings

Topological properties change abruptly in 2008, signaling the crisis.

Gradual topological changes start in 2005, indicating early warning signs.

Partial data reconstructions miss critical early-warning signals.

Abstract

The financial crisis clearly illustrated the importance of characterizing the level of 'systemic' risk associated with an entire credit network, rather than with single institutions. However, the interplay between financial distress and topological changes is still poorly understood. Here we analyze the quarterly interbank exposures among Dutch banks over the period 1998-2008, ending with the crisis. After controlling for the link density, many topological properties display an abrupt change in 2008, providing a clear - but unpredictable - signature of the crisis. By contrast, if the heterogeneity of banks' connectivity is controlled for, the same properties show a gradual transition to the crisis, starting in 2005 and preceded by an even earlier period during which anomalous debt loops could have led to the underestimation of counter-party risk. These early-warning signals are undetectable if the network is reconstructed from partial bank-specific data, as routinely done. We discuss important implications for bank regulatory policies.