Interconnectedness as a Source of Uncertainty in Systemic Risk

32 Pages Posted: 3 Feb 2016 Last revised: 20 Feb 2016

See all articles by Tarik Roukny

Tarik Roukny

Massachusetts Institute of Technology (MIT); KU Leuven - Faculty of Business and Economics (FEB)

Stefano Battiston

University of Zurich - Department of Banking and Finance; Swiss Finance Institute

Joseph E. Stiglitz

Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)

Date Written: February 2, 2016

Abstract

Financial networks have shown to be important in understanding systemic events in credit markets. In this paper, we investigate how the structure of those networks can affect the capacity of regulators to assess the level of systemic risk. We introduce a model to compute the individual and systemic probability of default in a system of banks connected in a generic network of credit contracts and exposed to external shocks with a generic correlation structure. Even in the presence of complete knowledge, we identify conditions on the network for the emergence of multiple equilibria. Multiple equilibria give rise to uncertainty in the determination of the default probability. We show how this uncertainty can affect the estimation of systemic risk in terms of expected losses. We further quantify the effects of cyclicality, leverage, volatility and correlations. Our results are relevant to the current policy discussions on new regulatory framework to deal with systemic events of distress as well as on the desirable level of regulatory data disclosure.

Keywords: Systemic Risk, Financial Networks, Uncertainty, Interconnectedness, Contagion

JEL Classification: E58, D81, G21

Suggested Citation

Roukny, Tarik and Battiston, Stefano and Stiglitz, Joseph E., Interconnectedness as a Source of Uncertainty in Systemic Risk (February 2, 2016). Columbia Business School Research Paper No. 16-14. Available at SSRN: https://ssrn.com/abstract=2726631 or http://dx.doi.org/10.2139/ssrn.2726631

Tarik Roukny (Contact Author)

Massachusetts Institute of Technology (MIT) ( email )

77 Massachusetts Avenue
50 Memorial Drive
Cambridge, MA 02139-4307
United States

KU Leuven - Faculty of Business and Economics (FEB) ( email )

Naamsestraat 69
Leuven, B-3000
Belgium

Stefano Battiston

University of Zurich - Department of Banking and Finance ( email )

Andreasstrasse 15
Zürich, 8050
Switzerland

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Joseph E. Stiglitz

Columbia Business School - Finance and Economics ( email )

3022 Broadway
814 Uris Hall
New York, NY 10027
United States
(212) 854-0671 (Phone)
(212) 662-8474 (Fax)

HOME PAGE: http://www.josephstiglitz.com

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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