Inherent Instability: Scenario-Free Analysis of Financial Systems with Interacting Contagion Channels

INET Oxford Working Paper No. 2019-10

96 Pages Posted: 4 Jul 2019

See all articles by Garbrand Wiersema

Garbrand Wiersema

University of Oxford; University of Oxford - Institute for New Economic Thinking at the Oxford Martin School; University of Oxford - Mathematical Institute

Alissa M. Kleinnijenhuis

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School, Students ; University of Oxford - Oxford-Man Institute of Quantitative Finance, Students ; University of Oxford - Mathematical Institute

Thom Wetzer

University of Oxford, Students ; University of Oxford - Oxford-Man Institute of Quantitative Finance, Students ; Institute for New Economic Thinking at the Oxford Martin School

J. Doyne Farmer

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School; Santa Fe Institute

Date Written: June 22, 2019

Abstract

Currently financial stress test simulations that take into account multiple interacting contagion mechanisms are conditional on a specific, subjectively imposed stress-scenario. Eigenvalue-based approaches, in contrast, provide a scenario-independent measure of systemic stability, but only handle a single contagion mechanism. We develop an eigenvalue-based approach that gives the best of both worlds, allowing analysis of multiple, interacting contagion channels without the need to impose a subjective stress scenario. This allows us to demonstrate that the instability due to interacting channels can far exceed that of the sum of the individual channels acting alone. We derive an analytic formula in the limit of a large number of institutions that gives the instability threshold as a function of the relative size and intensity of contagion channels, providing valuable insights into financial stability whilst requiring very little data to be calibrated to real financial systems.

Keywords: Financial Stability, Systemic Risk, Interacting Contagion Channels, Financial Contagion, Multiplex Networks, Stress Test, Liquidity-Solvency Nexus

JEL Classification: G01, G17, G18, G21, G23, G28

Suggested Citation

Wiersema, Garbrand and Kleinnijenhuis, Alissa M. and Wetzer, Thom and Farmer, J. Doyne, Inherent Instability: Scenario-Free Analysis of Financial Systems with Interacting Contagion Channels (June 22, 2019). INET Oxford Working Paper No. 2019-10. Available at SSRN: https://ssrn.com/abstract=3408533 or http://dx.doi.org/10.2139/ssrn.3408533

Garbrand Wiersema (Contact Author)

University of Oxford ( email )

Mansfield Road
Oxford, Oxfordshire OX1 4AU
United Kingdom

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School ( email )

Eagle House
Walton Well Road
Oxford, OX2 6ED
United Kingdom

University of Oxford - Mathematical Institute ( email )

Andrew Wiles Building
Radcliffe Observatory Quarter (550)
Oxford, OX2 6GG
United Kingdom

Alissa M. Kleinnijenhuis

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School, Students ( email )

Oxford
United Kingdom

University of Oxford - Oxford-Man Institute of Quantitative Finance, Students ( email )

Oxford
United Kingdom

University of Oxford - Mathematical Institute ( email )

United Kingdom

Thom Wetzer

University of Oxford, Students ( email )

Oxford
United Kingdom

University of Oxford - Oxford-Man Institute of Quantitative Finance, Students ( email )

Oxford
United Kingdom

Institute for New Economic Thinking at the Oxford Martin School ( email )

Eagle House
Walton Well Road
Oxford, OX2 6ED
United Kingdom

J. Doyne Farmer

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School ( email )

Eagle House
Walton Well Road
Oxford, OX2 6ED
United Kingdom

HOME PAGE: http://www.inet.ox.ac.uk/people/view/4

Santa Fe Institute ( email )

1399 Hyde Park Road
Santa Fe, NM 87501
United States
505-984-8800 (Phone)
505-982-0565 (Fax)

HOME PAGE: http://www.santafe.edu/~jdf/

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