Its been three months since the last “Research update” and a number of interesting papers have been published meanwhile. Please let me know if you have one to add.

An agent-based model of payment systems by Marco Galbiati and Kimmo Soramäki (Journal of Economic Dynamics and Control) builds an agent based model where banks choose the amount of liquidity to settle a given flow of payments. The paper pays special attention to a realistic settlement process with complex dynamics and studies the equilibrium level of liquidity that is a result of the game between the banks. The paper investigates liquidity usage with various system sizes and volumes, and under different liquidity cost parameters.

The Brazilian Interbank Network Structure and Systemic Risk by  Edson Bastos e Santos and Rama Cont (Banco Central do Brasil Working Paper 219) uses unique data on bilateral exposures between financial institutions in Brazil. They explore the empirical properties of the network and relate them to capital structure of the banks. They find that the network is best modeled as a directed scale-free (weighted) graph with heavy tailed degree and weight distributions.

Network Structure and Systemic Risk in Banking Systems by Rama Cont, Amal Moussa and Edson Bastos e Santos studies the potential for default contagion using the same data set as above. They find that network-based measures of connectivity and concentration of exposures contribute to the systemic importance of an institution.  Imposing capital measures on the basis of the network based “Contagion index” allows a lower level of capital across the system for given level of protection than imposing them uniformly across all banks.

Norwegian overnight interbank interest rates by Akram, Q. Farooq and Casper Christophersen (Norges Bank Staff Memo) infers actual interest rates from the advances and returns settled in the Norwegian payment system and proposes a new overnight interest rate based upon them (NONIA). The paper investigates the properties and evaluates the reliability of the interest rate both under normal conditions and during the recent financial crisis.

Mapping Systemic Risk in the International Banking Network by Rod Garrett, Lavan Mahadeva and Katya Svirydenska (Bank of England Working Paper) partitions banking groups from 21 countries into modules that reflect the ease at which stress is transmitted between the banks within a cluster. They use BIS data on international banking group exposures and find substantial changes over the time period of 1985 to 2009. The image below shows the network in Q3 of 2009.

Monitoring the unsecured interbank money market using TARGET2 data by Ronald Heijmans, Richard Heuver and Daniëlle Walraven (DNB Working Papers, No 276) extends the algorithm by Furfine (1999) and identifies loans between Dutch banks up to a maturity of one year. Based on the new algorithm they develop a policy tool to monitor the interbank money market, both at the level of the market and at individual banks. (Note: the match -command in FNA provides a similar algorithm as the one used in their paper)

I get this question asked every once in a while and here are some thoughts, personal experiences and little analysis of the Financial Networks Research Database.

Looking at the database (n=78), most articles were published as working papers or equivalent, a majority of which in central bank series. This is natural as central banks have access to detailed bilateral data required for any empirical analysis. As the surge in research on financial networks is rather new and the publication process time-consuming, some of them will likely end up in peer-reviewed journals. About a quarter of the papers in the database had already been published. The remaining ones appeared in Financial Stability Reviews or other reports or were still in the publication process (and were classified as mimeos). Of course, we need to keep in mind that the database consists likely a biased sample of all relevant research.

The most popular was the Journal of Economic Dynamics and Control with four papers including one by Marco Galbiati and me which took about two years to go through. Other finance/economics publications included various field journals such as Journal of Finance, Financial Markets, Institutions, and Instruments, Journal of Banking & Finance, and Journal of Money, Credit and Banking. For work related to central bank interests, the International Journal of Central Banking has become well appreciated even though it was launched only in 2008.

The study of networks is an interdisciplinary subject and quite a few papers were featured in physics journals such as Physica A, J. Statistical Mechanics or The European Physical Journal B. In practice the choice of publication venue is also related to what is appreciated by your peer group and to which groups you might be interested in reaching with your research. I myself have a few articles in Physica A. The journal has published a lot of theoretical work on the dynamics and statistical properties of complex networks and we thought they might be interested in our empirical work on network of payment flows between US banks.

Sociology and social network analysis – the oldest field in the study of networks – do not have any papers in the database. The new journal Social Network Analysis and Mining might fill this void. According to the Introduction to the first issue, network analysis in all disciplines is welcome and within the journal’s scope.

Happy to hear any comments.

We have a new year again and its a good time to collect research done last year on financial networks. As last year was quite busy, the collection of papers that I had found or that had been sent to me was getting somewhat long and cumbersome to maintain.

As a consequence I decided to put the data in a database and add a form for anyone to add their research to it. I will continue to check the entries and maintain the quality of the list. Other new features include a free text search on the articles and ability and sort entries by year, title and first author. See all 22 articles added last year.

Below are a few recent papers that I have come across. Please let me know if you have one to add.

Inter-Sector Relations in the Portuguese Economy: an Application of Contingent Claim Analysis by Nuno Silva (Bank of Portugal Financial Stability report) builds a network of bilateral relations between sectors of the Portuguese economy and simulates a sudden loss on non-financial corporations equity and an increase in credit impairment. These results highlight the importance of the banking system in the economy. Any shock in the financial sector has more impact on the overall system than a shock in other sectors. The model is based on the Gray, Merton and Bodie (2007) model where the economy is represented as a set of balance sheets interrelated by equity and implicit guarantees on debt payments. The approach has been used by Castren and Kavonius (2009) for euro area sectors as well.

Interbank tiering and money center banks by Ben Craig and Goetz von Peter (BIS working paper) provides evidence that interbank markets are tiered rather than flat. Most banks do not lend to each other directly but through money center banks acting as intermediaries. They use Bundesbank data on bilateral interbank exposures among 1800 banks.

Analyzing Systemic Risk with Financial Networks: An Application During a Financial Crash by Burak Saltoglu and Taylan Eren Yenilmez analyze the network properties of the Turkish overnight money market during the financial crisis and propose a centrality measure to monitor and identify systemically important institutions in the financial system.

Completeness, interconnectedness and distribution of interbank exposures – a parameterized analysis of the stability of financial networks by Angelika Sachs (Bundesbank Working paper) finds that financial stability depends not only on the completeness and interconnectedness of the network but also on the distribution of interbank exposures within the system. More concentrated networks are less stable. A network with asset concentration among core banks is less stable than a random graph with banks of homogeneous size. The results come from simulations on domino effects on random structures within realistic aggregate balance sheet structures.

National Security and Global Financial Governance by Annelies Z. Kamra discusses how network analysis of the financial system can be used to analyze and improve national security. These strategies can include checks to stop cascades and regulations to break up actors with high measures of centrality.

The Transaction Network in Japan’s Interbank Money Markets by Kei Imakubo and Yutaka Soejima look at the structural changes in the Japanese money markets. They find that that interbank payment flows in Japan have changed from a star-shaped network with money brokers mediating at the hub to a decentralized network with numerous other channels. Another paper by the same authors, The Microstructure of Japan’s Interbank Money Market: Simulating Contagion of Intraday Flow of Funds Using BOJ-NET Payment Data analyzes and runs simulations on the payment network to understand the intraday flow of funds within Japan’s interbank money market, especially recycling of the “receipt-driven payments”.

I hope to post another update in a few months.

Valdis Krebs has prepared an interesting visualization on the intersecting ownership of CDOs using data from ProPublica (see Interactive: CDOs’ Interlocking Ownership). A small picture is reproduced below with green nodes as investment banks and the blue nodes as the various CDOs involved in cross-ownership. See the original page for more details.

Circular CDOs: Contagion in the Financial Industry

The summer was a busy time for research on financial networks, ranging from interlinkages between economies via interbank money markets to financial infrastructures. One sentence summaries of eight papers are below.  Let me know if you have a relevant paper or work that I can add to the list.

“Analysing Interconnectivity among Economies”

Alfred Wong and Tom Fong study how interconnected relationships between economies can be disentangled into simple and quantifiable bilateral interdependence linkages, using 11 Asia-Pacific economies as an example.  Hong Kong Monetary Authority Working Papers No. 1003. (download)

“Systemic risk, financial contagion and financial fragility”

Serafín Martínez-Jaramillo, Omar Pérez Péreza, Fernando Avila Embriza and Fabrizio López Gallo Deya model systemic risk with two main components: a random shock that weakens one or more financial institutions and a transmission mechanism which transmits and possibly exacerbates such negative effects to the rest of the banking network. Journal of Economic Dynamics and Control (in press, link to sciencedirect)

“Systemic risk in a network model of interbank markets with central bank activity”

Co-Pierre Georg and Jenny Poschmann investigate which influence central bank activity has on interbank markets. Jena Economic Research Papers No. 2010-033. (download)

“Peer monitoring or contagion? Interbank market exposure and bank risk”

F.R. Liedorp, L. Medema, M. Koetter, R.H. Koning, and I. van Lelyveld test if interconnectedness in the interbank market is a channel through which banks affect each others riskiness. The evidence is based on quarterly bilateral exposures of all banks active in the Dutch interbank market between 1998 and 2008.  DNB working paper No. 248. (download).

“The sterling unsecured loan market during 2006-08: insights from network theory”

Anne Wetherilt, Peter Zimmerman and Kimmo Soramäki analyze empirically the unsecured overnight money market in the United Kingdom as a network of relationships and examine how the structure has changed over the recent period of crisis. Bank of England Working Paper No 398. (download)

“What do network theory and endogenous risk theory have to say about the effects of central counterparties on systemic stability?”

Jean-Pierre Zigrand’s paper considers what network theory can say about the effects of CCPs on systemic stability and how do different CCP structures (e.g. one vs multiple CCPs) alter systemic risk. Banque de France Financial Stability Review No 14. (download)

“Liquidity costs and tiering in large-value payment systems”

Mark Adams, Marco Galbiati and Simone Giansante develop and simulates a model of the emergence of networks in an interbank RTGS payment system. Bank of England Working Paper No. 399. (download)

“Liquidity-saving mechanisms and bank behaviour”

Marco Galbiati and Kimmo Soramäki develop a simple agent based model and investigate the effect of liquidity-saving mechanisms (LSMs) in interbank payment systems.  The paper is published as Bank of England Working Paper No 400. (download)

A new paper by Farooq Akram and Casper Christophersen entitled “Interbank overnight interest rates – gains from systemic importance” analyses the Norwegian overnight interbank interest rates paid by banks. They find that during the Financial crisis, the interest rates were substantially below indicative quotes of interest rates provided by major banks. The interest rate variation is explained by the relative size and connectedness of the banks, implying favorable terms for banks of systemic importance.

Moreover, interest rates are found to depend not only on overall liquidity in the interbank market, but possibly on its distribution among banks as well, suggesting exploitation of market power by banks with surplus liquidity. They also find evidence of stronger effects on interest rates of systemic importance, credit ratings and liquidity demand and supply since the start of the current financial crisis.

An open-source implementation of the algorithm for uncovering the interbank loans was developed as part of this project. The algorithm is available as part of the Financial Network Analyzer.

The European Central Bank published on 1 June a special feature entitled “Financial Networks and Financial Stability” in its Financial Stability Review.

The recent global financial crisis has illustrated the role of financial linkages as a channel for the propagation of shocks. It also brought to the fore the concept that institutions may be “too interconnected to fail”, in addition to the traditional concept of being “too big to fail”. [full article]

The article provides an overview on literature on financial network analysis and discusses what network theory can bring to the understanding of the concept of “too interconnected to fail”. The article was prepared by me and Silvia Gabrieli.

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 Sole, 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 Noemi Navarro 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.