Reduction of systemic risk by means of Pigouvian taxation

TL;DR

This paper demonstrates that implementing Pigouvian taxes on financial institutions, supported by a rescue fund, can significantly reduce systemic risk in financial networks while improving risk-adjusted returns.

Contribution

It introduces the concept of cascade risk as a network measure and shows how small Pigouvian taxes can effectively lower systemic risk in real financial networks.

Findings

Cascade risk can be reduced with small taxation rates.

Positive impact on risk-adjusted ROI despite ROI decline.

Network-based systemic risk measure is operationally defined.

Abstract

We analyze the possibility of reduction of systemic risk in financial markets through Pigouvian taxation of financial institutions which is used to support the rescue fund. We introduce the concept of the cascade risk with a clear operational definition as a subclass and a network related measure of the systemic risk. Using financial networks constructed from real Italian money market data and using realistic parameters, we show that the cascade risk can be substantially reduced by a small rate of taxation and by means of a simple strategy of the money transfer from the rescue fund to interbanking market subjects. Furthermore, we show that while negative effects on the return on investment ($ROI$) are direct and certain, an overall positive effect on risk adjusted return on investments ($ROI^{RA}$) is visible. Please note that \emph{the taxation} is introduced as a monetary/regulatory, not as a fiscal measure, as the term could suggest. \emph{The rescue fund} is implemented in a form of a common reserve fund.