The multi-layer network nature of systemic risk and its implications for the costs of financial crises

Abstract

The inability to see and quantify systemic financial risk comes at an immense social cost. Systemic risk in the financial system arises to a large extent as a consequence of the interconnectedness of its institutions, which are linked through networks of different types of financial contracts, such as credit, derivatives, foreign exchange and securities. The interplay of the various exposure networks can be represented as layers in a financial multi-layer network. In this work we quantify the daily contributions to systemic risk from four layers of the Mexican banking system from 2007-2013. We show that focusing on a single layer underestimates the total systemic risk by up to 90%. By assigning systemic risk levels to individual banks we study the systemic risk profile of the Mexican banking system on all market layers. This profile can be used to quantify systemic risk on a national level in terms of nation-wide expected systemic losses. We show that market-based systemic risk indicators systematically underestimate expected systemic losses. We find that expected systemic losses are up to a factor four higher now than before the financial crisis of 2007-2008. We find that systemic risk contributions of individual transactions can be up to a factor of thousand higher than the corresponding credit risk, which creates huge risks for the public. We find an intriguing non-linear effect whereby the sum of systemic risk of all layers underestimates the total risk. The method presented here is the first objective data driven quantification of systemic risk on national scales that reveal its true levels.

Network centrality and funding rates in the e-MID interbank market

“…In the financial economic literature network analysis has mostly been applied to payment systems, interbank lending markets, and more recently extended to capture the mutual exposure of financial institutions to other asset classes, including derivatives contracts, in a multilayer networks framework (Bargigli et al (2015), Leon et al (2014), Molina-Borboa et al (2015), Aldasoro and Alves (2015), Poledna et al (2015)). …”

Basel III capital surcharges for G-SIBs are far less effective in managing systemic risk in comparison to network-based, systemic risk-dependent financial transaction taxes

“…A major problem in NW-based SR management is to provide agents with incentives to rearrange their local contracts so that global (system-wide) SR is reduced. Recently, it has been noted empirically that individual transactions in the interbank market alter the SR in the total financial system in a measurable way [26,27]. This allows an estimation of the marginal SR associated with financial transactions, a fact that has been used to propose a tax on systemically relevant transactions [26].…”

Multiplex Networks of the Guarantee Market: Evidence from China

“…For example, Poledna et al [26] find that modeling contagion using each layer independently can lead to an underestimation of systemic risk. Therefore, the multiplex network method is useful in improving our understanding of complex systems by taking such multilayer features into account.…”