Understanding Financial Contagion: A Complexity Modeling Perspective

TL;DR

This paper reviews how complexity science, especially network models, helps understand systemic risk and financial contagion, emphasizing the importance of interconnectedness and the limitations of traditional risk management tools.

Contribution

It provides a comprehensive overview of network-based models of financial contagion and discusses the impact of interconnectedness on systemic risk.

Findings

Interconnectedness amplifies systemic risk.

Standard risk management tools may increase systemic vulnerability.

Network models reveal mechanisms of shock propagation.

Abstract

This chapter reviews key contributions of complexity science to the study of systemic risk in financial systems. The focus is on network models of financial contagion, where I explore various mechanisms of shock propagation, such as counterparty default risk and overlapping portfolios. I highlight how the interconnectedness of financial institutions can amplify risk, and I discuss how standard risk management tools, which neglect these interactions, can increase systemic risk.