Size and Complexity in Model Financial Systems

37 Pages Posted: 8 Oct 2012

See all articles by Nimalan Arinaminpathy

Nimalan Arinaminpathy

Imperial College London - School of Public Health

Sujit Kapadia

Bank of England; European Central Bank (ECB)

Robert May

University of Oxford

Date Written: October 7, 2012

Abstract

The global financial crisis has precipitated an increasing appreciation of the need for a systemic perspective towards financial stability. For example: What role do large banks play in systemic risk? How should capital adequacy standards recognize this role? How is stability shaped by concentration and diversification in the financial system? We explore these questions using a deliberately simplified, dynamical model of a banking system which combines three different channels for direct spillovers from one bank to another: liquidity hoarding, asset price contagion, and the propagation of defaults via counterparty credit risk. Importantly, we also introduce a mechanism for capturing how swings in ‘confidence’ in the system may contribute to instability. Our results highlight that the importance of relatively large, well-connected banks in system stability scales more than proportionately with their size: the impact of their collapse arises not only from their connectivity, but also from their effect on confidence in the system. Imposing tougher capital requirements on larger banks than smaller ones can thus enhance the resilience of the system. Moreover, these effects are more pronounced in more concentrated systems, and continue to apply even when allowing for potential diversification benefits which may be realised by larger banks. We discuss some tentative implications for policy, as well as conceptual analogies in ecosystem stability, and in the control of infectious diseases.

Keywords: systemic risk, financial crises, contagion, network models, liquidity risk, confidence

JEL Classification: D85, G01, G21, G28

Suggested Citation

Arinaminpathy, Nimalan and Kapadia, Sujit and Kapadia, Sujit and May, Robert, Size and Complexity in Model Financial Systems (October 7, 2012). Bank of England Working Paper No. 465, Available at SSRN: https://ssrn.com/abstract=2158380 or http://dx.doi.org/10.2139/ssrn.2158380

Nimalan Arinaminpathy

Imperial College London - School of Public Health ( email )

London
United Kingdom

Sujit Kapadia (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom
020-7601-5507 (Phone)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Robert May

University of Oxford ( email )

Department of Economics
Manor Road
Oxford, OX1 3UQ
United Kingdom

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