A new paper by Farooq Akram and Casper Christophersen entitled "Interbank overnight interest rates – gains from systemic importance" analyses the Norvegian 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.

Committee to Establish a National Institute of Finance (CE-NIF), the Center for Financial Policy at the R.H. Smith School of Business at the University of Maryland and the Pew Financial Reform Project are organizing a workshop on “Frameworks for Systemic Risk Monitoring.” It will be held in Washington DC on June 21-22, 2010.

The conference brings together leading minds from academia, industry, and government (see agenda). Key speakers include Markus Brunnermeier (Princeton), Simon Johnson (MIT), Raghuram Rajan (Chicago), John Geanakoplos (Yale), Rama Cont (Columbia) and Alan King (IBM Research).

Both versions of the regulatory reform legislation that were recently passed in US Congress call for increased efforts to monitor the financial system and respond to signs of heightened systemic risk. Regulators will need new tools to realize this mandate. The aim of the workshop is to move the debate forward on the development of these new tools. The conference will discuss alternative frameworks for understanding systemic risk and strategies for risk monitoring and the implications each of them has for data and systems requirements. A background paper which reviews the debate on systemic risk is also available for download.

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 Solé 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 by Jorge Chan-Lau, Marco A. Espinosa-Vega, Kay Giesecke, and Juan Solé 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 Noemí 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.

Risk Europe 2010 (Frankfurt, 25-28 May) will have a seminar on “Using financial network models for counterparty risk analysis: from micro to macro”  by Olli Castren (European Central Bank) and a session on “Using network theory to assess systemic risk” presented by me. Risk Europe is the Risk Magazines annual flagship event and carries this year the theme of “Navigating regulatory reform and reduced liquidity in a changing landscape”.

IMF organizes a conference on “Operationalizing Systemic Risk Monitoring” (Washington DC, 26-28 May). The conference will bring together policy makers, industry and academia to discuss new approaches for identifying systemically important institutions, and for measuring and modeling systemic risk. The conference will have one day devoted to the use of network analysis for assessing systemic risk (see IMF report in previous post). I will participate in a panel session together with Sheri Markose and Rama Cont on “How to Measure Systemic Interconnectedness – Network Perspectives”.

Also on the same week Deutsche Bundesbank is organizing a workshop on “Interconnectedness of Financial Institutions: Microeconomic Evidence, Aggregated Outcomes, and Consequences for Economic Policy”  (Frankfurt, 26 May) to discuss the consequences of changes in the financial system and in particular of a greater degree of interconnectedness of financial institutions.

Recently the idea has been floated that systemically important financial institutions should be charged insurance premia to cover for government support in times of stress. The recent IMF report (April 2010) for G20 ministers now suggests that:

A risk-adjusted rate could be designed to address the contribution to systemic risk. Ideally, the rate would vary according to the size of the systemic risk externality, e.g., based on a network model which would take into account all possible channels of contagion.

In order to operationalize the network approach, however, more both theoretical and empirical research is needed – as well as access to more frequent and granular data.

A risk-adjusted rate could be designed to address the

contribution to systemic risk. Ideally, the rate would vary according to the size of the systemic risk

externality, e.g., based on a network model which would take into account all possible channels of

contagionA risk-adjusted rate could be designed to address the

contribution to systemic risk. Ideally, the rate would vary according to the size of the systemic risk

externality, e.g., based on a network model which would take into account all possible channels of

contagion.

New YorkTimes (1 May 2010) published a great visualization (Bill Marsh / The New York Times) of the debt relationships between European countries based on public data by BIS. Its reproduced below.

The Visual Science series of New York Times has many other captivating visualizations of data as well.

The ECB conference "Recent advances in modelling systemic risk using network analysis" was featured today in Securities Operations Week – a weekly publication focused on US and global securities operations, technology and compliance:

"The financial crisis that began to emerge in 2007 and that gained steam in 2008 famously gave rise to the oft-cited slogan “too big to fail.” It also saw the coinage of a lesser-known catchphrase kicked around commonly now in research circles: “too networked to fail". A summation released last week by the European Central Bank offers what may be the best discussion to date on the subject. [read the full article (pdf)]

The year 2009 is now gone and its time to look back at the research on financial networks and related topics from that year. Here are some that I found. Please help me add to the list.

Liasons Dangereuses: Incresing connectivity, risk sharing and systemic risk (by Stefano Battiston, Domenico Delli Gatti, Mauro Gallegati, Bruce C. Greenwald and Joseph E. Stiglitz). [link]

Rethinking the Financial Network (A speech by Andrew Haldane t the Financial Student Association, Amsterdam April 2009). [link]

On the Informational Properties of Trading Networks (by Lada Adamic, Celso Brunetti, Jeffrey H. Harris, and Andrei A. Kirilenko). [link]

The Financial Crisis and the Systemic Failure of Academic Economics (by David Colander, Hans Föllmer, Armin Haas, Michael D. Goldberg, Katarina Juselius, Alan Kirman, Thomas Lux, and Birgitte Sloth). Univ. of Copenhagen Dept. of Economics Discussion Paper No. 09-03. [link]

Identifying Community Structures from Network Data via Maximum Likelihood Methods (by Jernej Copi, Matthew O. Jackson, and Alan Kirman), The B.E. Journal of Theoretical Economics: Vol. 9 : Iss. 1 (Contributions), Article 30. [link]

Pedro Romero has three papers on banking networks: "The Evolution of Economic Networks" [link], "Banking Crises and Institutional Arrangements". [link], and "Bank Runs, Banking Contracts, and Social Networks" [link]

A Comparison of the Director Networks of the Main Listed Companies in France, Germany, Italy, the United Kingdom, and the United States (by Paolo Santella, Carlo Drago, Andrea Polo, and Enrico Gagliardi). [link]

Structure and Stability in Payment Networks – A Panel Data Analysis of ARTIS Simulations (by Stefan Schmitz and Claus Puhr). [link]

Visualizing Stock-Mutual Fund Relationships through Social Network Analysis (by Rafael Solis), Global Journal of Finance and Banking Issues Vol. 3. No. 3. 2009. [link]

The sterling unsecured loan market during 2006–2008: insights from network topology (Anne Wetherilt, Peter Zimmerman and Kimmo Soramaki); in Leinonen (ed) Simulation analyses and stress testing of payment networks, Bank of Finland Scientific monographs E:42. [link]