What Makes Financial Networks Special? Distorted Investment Incentives, Regulation, and Systemic Risk Measurement
54 Pages Posted: 18 Jan 2019 Last revised: 7 May 2019
Date Written: March 1, 2019
We provide an overview of some key trends and features of financial networks related to systemic risk. We also provide a new network model of inter-dependencies, and use this to analyze the incentives that financial institutions have to choose the risk in their portfolios, their trading partners, and the correlation of their portfolios with those direct and indirect counterparties. We show that they have incentives to choose excessively risky portfolios, and to under-diversify in terms of choosing too few counterparties with whom to share risks. We also show that banks have strong incentives to perfectly correlate the situations in which their portfolios perform poorly, which generally increases systemic risk. We then provide a measure of financial centrality in terms of the consequences of a given institution's portfolio on the potential defaults of other institutions. We discuss minimum interventions or capital needed to ensure systemic solvency.
Keywords: Financial Networks, Markets, Systemic Risk, Financial Crises, Correlated Portfolios, Default Risk, Networks, Banks
JEL Classification: D85, F15, F34, F36, F65, G15, G32, G33, G38
Suggested Citation: Suggested Citation