Managing Default Contagion in Inhomogeneous Financial Networks

TL;DR

This paper models systemic risk in inhomogeneous interbank networks, quantifies contagion effects from local shocks, and proposes local capital requirements to enhance financial stability.

Contribution

It introduces a flexible network model capturing heterogeneity, extends previous work to networks without second moment degree distributions, and derives local capital requirements for resilience.

Findings

Small initial shocks can cause large cascades in certain networks.

Resilience can be achieved through local capital requirements.

The model fits real data and informs regulatory policies.

Abstract

The aim of this paper is to quantify and manage systemic risk caused by default contagion in the interbank market. We model the market as a random directed network, where the vertices represent financial institutions and the weighted edges monetary exposures between them. Our model captures the strong degree of heterogeneity observed in empirical data and the parameters can easily be fitted to real data sets. One of our main results allows us to determine the impact of local shocks, where initially some banks default, to the entire system and the wider economy. Here the impact is measured by some index of total systemic importance of all eventually defaulted institutions. As a central application, we characterize resilient and non-resilient cases. In particular, for the prominent case where the network has a degree sequence without second moment, we show that a small number of initially defaulted banks can trigger a substantial default cascade. Our results complement and extend significantly earlier findings derived in the configuration model where the existence of a second moment of the degree distribution is assumed. As a second main contribution, paralleling regulatory discussions, we determine minimal capital requirements for financial institutions sufficient to make the network resilient to small shocks. An appealing feature of these capital requirements is that they can be determined locally by each institution without knowing the complete network structure as they basically only depend on the institution's exposures to its counterparties.