Network versus portfolio structure in financial systems

TL;DR

This paper investigates how network topology and portfolio diversity influence systemic risk in financial systems, revealing that optimal asset allocation depends on network structure and that certain banks can act as firewalls to prevent systemic failures.

Contribution

It introduces a model linking network topology, externalities, and portfolio diversity, showing how to minimize systemic risk through targeted asset allocation and identifying key banks as firewalls.

Findings

Portfolio diversity reduces systemic risk but increases individual default risk.

Network topology affects optimal asset allocation for risk minimization.

Certain banks can serve as firewalls to contain systemic failures.

Abstract

The question of how to stabilize financial systems has attracted considerable attention since the global financial crisis of 2007-2009. Recently, Beale et al. ("Individual versus systemic risk and the regulator's dilemma", Proc Natl Acad Sci USA 108: 12647-12652, 2011) demonstrated that higher portfolio diversity among banks would reduce systemic risk by decreasing the risk of simultaneous defaults at the expense of a higher likelihood of individual defaults. In practice, however, a bank default has an externality in that it undermines other banks' balance sheets. This paper explores how each of these different sources of risk, simultaneity risk and externality, contributes to systemic risk. The results show that the allocation of external assets that minimizes systemic risk varies with the topology of the financial network as long as asset returns have negative correlations. In the model, a well-known centrality measure, PageRank, reflects an appropriately defined "infectiveness" of a bank. An important result is that the most infective bank need not always be the safest bank. Under certain circumstances, the most infective node should act as a firewall to prevent large-scale collective defaults. The introduction of a counteractive portfolio structure will significantly reduce systemic risk.