‘Too interconnected to fail’ financial network of US CDS market: Topological fragility and systemic risk

Abstract

A small segment of credit default swaps (CDS) on residential mortgage backed securities (RMBS) stand implicated in the 2007 financial crisis. The dominance of a few big players in the chains of insurance and reinsurance for CDS credit risk mitigation for banks' assets has led to the idea of too interconnected to fail (TITF) resulting, as in the case of AIG, of a tax payer bailout. We provide an empirical reconstruction of the US CDS network based on the FDIC Call Reports for off balance sheet bank data for the 4 th quarter in 2007 and 2008. The propagation of financial contagion in networks with dense clustering which reflects high concentration or localization of exposures between few participants will be identified as one that is TITF. Those that dominate in terms of network centrality and connectivity are called 'super-spreaders'. Management of systemic risk from bank failure in uncorrelated random networks is different to those with clustering. As systemic risk of highly connected financial firms in the CDS (or any other) financial markets is not priced into their holding of capital and collateral, we design a super-spreader tax based on eigenvector centrality of the banks which can mitigate potential socialized losses.

Systemic Risk from Global Financial Derivatives: A Network Analysis of Contagion and Its Mitigation with Super-Spreader Tax

“…The sparseness of the matrix relates to the fact that PP flows are zero and banks in the periphery of the network do not interact with one another. The localized clustering in the central core resembles the small world network property of being too interconnected and corresponds to the data-based CDS market network where this property was first identified in Markose et al (2012). Hence, the criticism Craig and von Peter level at extant financial networks literature is worth stating here.…”

CCPs and network stability in OTC derivatives markets

“…As in Markose, Giansante and Shaghaghi (2012) and Shaghaghi and Markose (2012), the algorithm does this in a way that minimizes the errors in the relevant row and column sums, subject to the constraint that the bilateral relationships are consistent with a core-periphery structure. In particular, we use the 'connectivity priors' about the nature of relationships between counterparties that were used in the MAGD exercise.…”

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“…Agent-based models, on the other hand, have been used to explic-itly investigate the propagation of bankruptcies in the financial system (see e.g. Battiston et al, 2009;Tedeschi et al, 2011;Lenzu and Tedeschi, 2012;Markose et al, 2012). When allowing for more than one agent, heterogeneity enters a model.…”