New Models on Financial Linkages

Cross-Border Financial Surveillance: A Network Perspective (IMF Working Paper 105 , April 2010 ) by Marco Espinosa-Vega and Juan Sole simulates different credit and funding shocks to the banking systems of a number of countries. Using cross-country bilateral exposures data from BIS they illustrate the contagion algorithms presented in the paper.

In a similar vein Assessing the Systemic Implications of Financial Linkages (Chapter II in IMF’s Global Financial Stability Report, April 2009) by Jorge Chan-Lau, Marco A. Espinosa-Vega, Kay Giesecke, and Juan Sole discusses four complementary approaches to assess direct and indirect financial sector systemic linkages:

• network approach which relies primarily on institutional data to contagion triggered by financial distress
• co-risk model which assesses common risk factors
• distress dependence matrix which is based on market data, but instead of looking at bilateral relationships as above, uses a composite time-varying multivariate distribution that captures linear (correlation) and nonlinear interdependence
• default intensity model which measures the probability of failures of a large fraction of financial institutions due to both direct and indirect systemic linkages

Network Analysis: Contagion Path Triggered by U.K. Failure in the model (Jorge Chan-Lau, Espinosa-Vega, Giesecke, and Solé, 2010)

Contagion in Financial Networks (Bank of England Working Paper No. 383, March 2010) by Prasanna Gai and Sujit Kapadia develops an analytical model of contagion in financial networks. The paper explores how the probability and potential impact of contagion is influenced by aggregate and idiosyncratic shocks, changes in network structure, and asset market liquidity. The paper is forthcoming in Proceedings of the Royal Society A.

Optimal Fragile Financial Networks (forthcoming) by Fabio Castiglionesi and NoemNavarro studies the endogenous formation of a financial network under a model where banks establish connection to co-insure their liquidity needs. The paper rationalizes the evidence of sparse network structures observed in the topology of interbank networks.