Global Stability of Banking Networks Against Financial Contagion: - PowerPoint PPT Presentation

Global Stability of Banking Networks Against Financial Contagion: Measures, Evaluations and Implications Bhaskar DasGupta Department of Computer Science University of Illinois at Chicago Chicago, IL 60607 bdasgup@uic.edu September 16, 2014 Based on the thesis work of my PhD student Lakshmi Kaligounder Joint works with Piotr Berman, Lakshmi Kaligounder and Marek Karpinski Bhaskar DasGupta (UIC) Global Stability of Banking Networks September 16, 2014 1 / 48

Outline of talk Introduction 1 Global stability of financial system 2 Theoretical (computational complexity and algorithmic) results Empirical results (with some theoretical justifications) Economic policy implications Future research 3 Bhaskar DasGupta (UIC) Global Stability of Banking Networks September 16, 2014 2 / 48

Introduction financial stability — an informal view Typical functions of financial systems in market-based economy borrowing from surplus units lending to deficit units Financial stability (informally) ability of financial system perform its key functions even in “stressful” situations Threats on stability may severely affect the functioning of the entire economy Bhaskar DasGupta (UIC) Global Stability of Banking Networks September 16, 2014 3 / 48

Introduction study of financial stability — some historical perspectives study of financial stability — some historical perspectives research works during “Great Depression” era Irving Fisher (1933) John Keynes (1936) Hyman Minsky (1977) instabilities are inherent ( i.e. , “systemic”) in many capitalist economies ⇒ ⇒ ⇒ ⇒ ⇒ ⇒ 1930s early 1980s 2007 great depression recession recession stock market collapse (black Tuesday) stock market collapse major bank failures real estate collapse high unemployment major bank almost failures (averted with government aid) high unemployment Bhaskar DasGupta (UIC) Global Stability of Banking Networks September 16, 2014 4 / 48

Introduction Cause for financial instability Why financial systems exhibit instability ? inherent property of system ( i.e. , systemic) ? caused by “a few” banks that are “too big to fail” ? due to government regulation or de-regulation ? random event, just happens ? Examples of conflicting opinions by Economists inherent (Minsky, 1977) de-regulation of banking and investment laws Yes (Ekelund and Thornton, 2008) No (Calabria, 2009) Bhaskar DasGupta (UIC) Global Stability of Banking Networks September 16, 2014 5 / 48

Introduction Motivation for studying financial instability Why study financial instability ? scientific curiosity working of a regulatory agency [Haldane and May, 2011; Berman et al. , 2014] what is the cause ? periodically evaluates network stability how can we measure it ? a a network ex ante for further analysis if flags a its evaluation is weak too many false positives may drain the finite resources of the agency, but vulnerability is too important to be left for an ex post analysis a a a Flagging a network as vulnerable does not necessarily imply that such is the case, but that such a network requires further analysis based on other aspects of free market economics that cannot be modeled ( e.g. , rumors, panic) Bhaskar DasGupta (UIC) Global Stability of Banking Networks September 16, 2014 6 / 48

Outline of talk Introduction 1 Global stability of financial system 2 Theoretical (computational complexity and algorithmic) results Empirical results (with some theoretical justifications) Economic policy implications Future research 3 Bhaskar DasGupta (UIC) Global Stability of Banking Networks September 16, 2014 7 / 48

Global stability of financial system General introduction To investigate financial networks, one must first settle questions of the following type: What is the model of the financial network ? How exactly failures of individual financial agencies propagate through the network to other agencies ? What is an appropriate global stability measure ? Bhaskar DasGupta (UIC) Global Stability of Banking Networks September 16, 2014 8 / 48

Global stability of financial system The model we extend and formalize an ex ante graph-theoretic models for banking networks under idiosyncratic shocks originally suggested by (Nier, Yang, Yorulmazer, Alentorn, 2007) directed graph with several parameters shock refers to loss of external assets network can be homogeneous (assets distributed equally among banks) heterogeneous (otherwise) Bhaskar DasGupta (UIC) Global Stability of Banking Networks September 16, 2014 9 / 48

Global stability of financial system The model parameters Details of the model parameterized node/edge-weighted directed graph G = ( V , E , Γ) G = ( V , E , Γ) G = ( V , E , Γ) Γ = {E , I , γ } Γ = {E , I , γ } Γ = {E , I , γ } E ∈ R E ∈ R E ∈ R total external asset I ∈ R I ∈ R I ∈ R total inter-bank exposure γ ∈ ( 0 , 1 ) γ ∈ ( 0 , 1 ) γ ∈ ( 0 , 1 ) ratio of equity to asset V n V V is set of n n banks � � � � � � � � � σ v ∈ [ 0 , 1 ] σ v ∈ [ 0 , 1 ] σ v ∈ [ 0 , 1 ] v ∈ V σ v = 1 v ∈ V σ v = 1 v ∈ V σ v = 1 weight of node v ∈ V v ∈ V v ∈ V v ∈ V share of total external asset for each bank v ∈ V v ∈ V E E E is set of m m m directed edges (direct inter-bank exposures) w ( e ) = w ( u , v ) > 0 w ( e ) = w ( u , v ) > 0 w ( e ) = w ( u , v ) > 0 e = ( u , v ) ∈ E weight of directed edge e = ( u , v ) ∈ E e = ( u , v ) ∈ E Bhaskar DasGupta (UIC) Global Stability of Banking Networks September 16, 2014 10 / 48

Global stability of financial system Balance sheet details of a node v Balance sheet details of a node (bank) v v v Assets ι v = � Liabilities ι v = � ι v = � w ( v , u ) w ( v , u ) total interbank asset w ( v , u ) ( v , u ) ∈ E ( v , u ) ∈ E ( v , u ) ∈ E b v = � b v = � b v = � w ( u , v ) total interbank w ( u , v ) w ( u , v ) effective share of borrowing e v = b v − ι v + σ v E e v = b v − ι v + σ v E e v = b v − ι v + σ v E ( u , v ) ∈ E ( u , v ) ∈ E ( u , v ) ∈ E total external asset a a a c v = γ a v net worth (equity) c v = γ a v c v = γ a v a v = b v + σ v E a v = b v + σ v E a v = b v + σ v E total asset d v d v d v customer deposit ℓ v = b v + c v + d v ℓ v = b v + c v + d v ℓ v = b v + c v + d v total liability a E a E a E is large enough such that e v > 0 e v > 0 e v > 0 a v a v a v = = = ℓ v ℓ v ℓ v balance sheet equation total asset total liability Bhaskar DasGupta (UIC) Global Stability of Banking Networks September 16, 2014 11 / 48

Global stability of financial system Two banking network models Two banking network models Homogeneous model E E E and I I I are equally distributed among the nodes and edges, respectively 1 / | V | for every node v ∈ V v ∈ V v ∈ V 1 / | V | 1 / | V | σ v σ v σ v = = = w ( e ) w ( e ) w ( e ) for every edge e ∈ E e ∈ E e ∈ E = = = I / | E | I / | E | I / | E | Heterogeneous model E I E and I E I are not necessarily equally distributed among the nodes and edges, respectively σ v ∈ ( 0 , 1 ) σ v ∈ ( 0 , 1 ) σ v ∈ ( 0 , 1 ) � � � v ∈ V σ v = 1 v ∈ V σ v = 1 v ∈ V σ v = 1 & � � � w ( e ) ∈ R + w ( e ) ∈ R + w ( e ) ∈ R + e ∈ E w ( e ) = I e ∈ E w ( e ) = I e ∈ E w ( e ) = I & Bhaskar DasGupta (UIC) Global Stability of Banking Networks September 16, 2014 12 / 48

Global stability of financial system How to estimate global stability ? How to estimate global stability ? Via so-called “stress test” give some banks a “shock” see if some of them fail see how these failures lead to failures of other banks • how does stress (“shock”) originate ? Next ◮ • how does stress (“shock”) propagate ? Bhaskar DasGupta (UIC) Global Stability of Banking Networks September 16, 2014 13 / 48

Global stability of financial system How does shock originate ? Origination of shock (initial bank failures) K Two additional parameters: K K and Φ Φ Φ 0 < K < 1 0 < K < 1 0 < K < 1 fraction of nodes that receive the shock 0 < Φ < 1 0 < Φ < 1 0 < Φ < 1 severity of the shock i.e. , by how much the external assets decrease One additional notation: V ✖ V ✖ V ✖ V ✖ V ✖ V ✖ subset of nodes that are shocked V ✖ (how V ✖ V ✖ is selected will be described later) (this is the so-called “shocking mechanism”) Continued to next slide ◮ Bhaskar DasGupta (UIC) Global Stability of Banking Networks September 16, 2014 14 / 48

Global stability of financial system How does shock originate ? (continued) Initiation of shock of magnitude Φ Φ Φ v ∈ V ✖ for all nodes v ∈ V ✖ v ∈ V ✖ , simultaneously decrease their external assets e v s v = Φ e v from e v e v by s v = Φ e v s v = Φ e v Φ parameter Φ Φ determines the “severity” of the shock if s v ≤ c v s v ≤ c v s v ≤ c v , v v v continues to operate with lower external asset if s v > c v s v > c v s v > c v , v v v dies ( i.e. , stops functioning) and “propagates” shock • meaning of “death” (of a node) Next ◮ • how do shocks propagate ? Bhaskar DasGupta (UIC) Global Stability of Banking Networks September 16, 2014 15 / 48