Q&A: Seven Questions on Financial Interconnectedness

Author:Co-Pierre Georg - Camelia Minoiu
Pages:9-14
 
FREE EXCERPT
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
(continued on page 10)

To continue reading

REQUEST YOUR TRIAL