Cross-border Portfolio Investment Networks and Indicators for Financial Crises

TL;DR

This paper analyzes cross-border investment networks from 2002 to 2012 to identify early-warning indicators for financial crises, focusing on network robustness and market interdependence, especially around the 2008 crisis.

Contribution

It introduces two novel early-warning indicators based on network analysis that can forecast financial instability and systemic risk.

Findings

Algebraic connectivity of equity networks drops before crises

High-degree offshore financial centers are linked to network fragility

Edge density of debt networks forecasts derivatives proliferation

Abstract

Cross-border equity and long-term debt securities portfolio investment networks are analysed from 2002 to 2012, covering the 2008 global financial crisis. They serve as network-proxies for measuring the robustness of the global financial system and the interdependence of financial markets, respectively. Two early-warning indicators for financial crises are identified: First, the algebraic connectivity of the equity securities network, as a measure for structural robustness, drops close to zero already in 2005, while there is an over-representation of high-degree off-shore financial centres among the countries most-related to this observation, suggesting an investigation of such nodes with respect to the structural stability of the global financial system. Second, using a phenomenological model, the edge density of the debt securities network is found to describe, and even forecast, the proliferation of several over-the-counter-traded financial derivatives, most prominently credit default swaps, enabling one to detect potentially dangerous levels of market interdependence and systemic risk.