Banking Regulation and Network-Topology Dependence of Iterative Risk-Trading Games

Abstract

In the context of understanding risk-regulatory behavior of financial institutions we propose a general dynamical game between several agents who pick their trading strategies depending on their individual risk-to-wealth ratio. The game is studied numerically for different network topologies. Consequences of topology are shown for the wealth time-series of agents, for the safety and efficiency of various types of networks. The model yields realistic-looking time-series of wealth and the cost of safety increases as a power-like function. The relevant model parameters should be controllable in reality. This setup allows a stringent analysis of the effects of different approaches of banking regulation as currently suggested by the Basle Committee of Banking Supervision. We find evidence that a tightening of the current regulatory framework does not necessarily lead to an improvement of the safety of the banking system. Moreover, the potential impact of catastrophic events like September 11, 2001, on the financial system can be measured within this framework.

Keywords: Banking Regulation, Bank Default, Network-topology Dependence, Risk-trading Game, Dynamic Decision Making Process

JEL Classification: C73, G28