Multichannel Contagion vs Stabilisation in Multiple Interconnected Financial Markets
35 Pages Posted: 25 Jan 2017 Last revised: 21 Mar 2017
Date Written: April 1, 2016
The theory of multilayer networks is in its early stages, and its development provides powerful and vital methods for understanding complex systems. Multilayer networks, in their multiplex form, have been introduced within the last three years to analysing the structure of financial systems, and existing studies have modelled and evaluated interdependencies of different type among financial institutions. The empirical studies have considered the structure as a non-interconnected multiplex rather than as an interconnected multiplex network. No mechanism of multichannel contagion has been modelled and empirically evaluated, and no multichannel stabilisation strategies for pre-emptive contagion containment have been designed. This paper formulates an interconnected multiplex structure, and a contagion mechanism among financial institutions due to bilateral exposures arising from institutions’ activity within different interconnected markets that compose the overall financial market. We introduce structural measures of absolute systemic risk and resilience, and relative systemic-risk indexes. The multiple-market systemic risk and resilience allow comparing the structural (in)stability of different financial system or the same system in different periods. The relative systemic-risk indexes of institutions acting in multiple markets allow comparing the institutions according to their relative contributions to overall structural instability within the same period. Based on the contagion mechanism and systemic-risk quantification, this study designs minimum-cost stabilisation strategies that act simultaneously on different markets and their interconnections, in order to effectively contain potential contagion progressing through the overall structure. The stabilisation strategies subtly affect the emergence process of structure to adaptively build in structural resilience and achieve pre-emptive stabilisation at a minimum cost for each institution and at no cost for the system as a whole. We empirically evaluate the new approach using large regulatory databases, maintained by the Prudential Regulatory Authority (PRA) of the Bank of England, that include verified capital requirements for UK-incorporated deposit takers and investment firms and granular information on their bilateral exposures due to transactions in the fixed-income market, securities-financing market, and derivatives market. The empirical simulations of the designed multichannel stabilisation strategies confirm their capability for containing contagion. The potential for multichannel contagion through the multiplex contributes more to systemic fragility than single-channel contagion, however multichannel stabilisation also contributes more to systemic resilience than single-channel stabilisation.
Keywords: multichannel contagion, multiple-market stabilisation, interconnected multiplex, systemic risk, systemic resilience
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