Q&A: Seven Questions on Financial Interconnectedness

• Author: Co-Pierre Georg - Camelia Minoiu
• Pages: 9-14

March 2014

9

Financial interconnectedness, the ensemble of relationships

among economic agents created through financial transac-

tions, can be an important source of systemic risk. A better

understanding of the consequences of financial interconnect-

edness through the lens of network analysis is currently a

leading objective of academics and policymakers. This Q&A

article provides brief answers to seven questions on financial

interconnectedness in light of a growing body of research on

financial networks, including contributions by the authors.

The findings of this literature suggest that financial intercon-

nectedness plays a crucial role in the transmission of shocks

and that there is a lot to learn from network analysis about

the resilience of financial systems.

Question 1. What is financial interconnectedness?

Financial interconnecte dness refers to direct and i ndirect

linkages a mong nancial inst itutions. ese lin kages can

take many forms. For exa mple, contractual connec tedness is

the dependency of one institut ion on another that stems from

contractual obligat ions (such as ownership, loans, and deriv-

atives) between the two inst itutions. Banks t hat participate

in the interbank ma rket, for instance, become interconnected

as they become exposed to one a nother through lendi ng and

borrowing operations. Fina ncial institutions also create com-

mon exposures when they invest i n the same asset ; this is a

more complex and less studied ty pe of linkage.

Both type s of linkages are closely related to economic phe-

nomena such as nancial contag ion and spillovers. Financial

contagion is the process by which an a dverse shock at one

nancial ins titution can have negative consequences for many

others. Contractua l connectedness i n the interbank ma rket

can lead to interbank contag ion, by which the default of one

bank leads to losses a nd the subsequent default of another

bank. is may t rigger a default cascade. Interconnectedness

due to common exposures can lead to spi llovers and corre-

lation in bank performa nce. When a liquidit y-constrained

bank sells o its a ssets, other ban ks may incur losses due to

the assets’ fal ling market price and mark-to-market pricing.

Analyzing t he interconnectedness of economic agents—

the ways in which they a re directly a nd indirectly con nect-

ed—can thus help shar pen our understandi ng of contagion

and spil lovers.

Question 2. What can be learned from modeling financial

interconnectedness among economic agents as a

network?

One of the key lessons from the globa l nancial cr isis is

that it is not sucient to supervise b anks at the micro level,

that is, by monitoring their ba lance sheets in isolation. Rath-

er, microprudential supervision needs to be c omplemented

with macroprudential oversig ht, which takes nancial inter-

connectedness into account. Net work theory can help us

understand the complex str ucture of modern nanci al sys-

tems. Using insights from the net work formation literature,

we can analyz e how markets are formed and how they evolve

over the business cycle. When we model the s et of nancial

linkages as a c omplex network, we can use the rich set of

tools from network theory to as sess the stability of the na n-

cial system. We can als o better understand wh ich areas of

the nancial s ystem are most vul nerable to shocks, which

banks’ defaults t rigger more subsequent defaults, and how

contagion spre ads.

Question 3. Is there a link between the structure of a

financial network and financial stability?

One of the most mature areas of na ncial network research

looks at how an initial defau lt is transmitt ed to the rest of

the nancial s ystem. Will the default cascad e “die out” aer a

few rounds, or will it eventua lly cause a systemic breakdown?

Network theory shows that many  nancial networks e xhibit

a so-called t ipping-point property: below a critica l level of

interconnectedness, in itial defaults a re contained irrespec-

tive of the network struct ure. Above this threshold, however,

initial default s can turn sy stemic, leading to the col lapse of

the entire nancia l system. is leads u s to ask under which

conditions the struct ure of nancial interconnectedness m at-

ters for contagion. Georg (2013) shows that during periods of

macroeconomic stress, the net work structure determines the

extent of contagion. Further more, some network structures

are more resilient to random shocks tha n others. Roukny and

others (2013) show that there is no network structure that is

universally most robus t.

Seven Questions on Financial Interconnectedness

Co-Pierre Georg and Camelia Minoiu

Q&A

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