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Financial networks and default-driven shocks: an application to banking systems

Financial networks and default-driven shocks: an application to banking systems. Francisco Hawas (*) Research Assistant Mathematical Modeling Center Universidad de Chile. (*) Joint project with Arturo Cifuentes and Alejandro Jofré. Motivation. Financial crisis (2007-2008)

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Financial networks and default-driven shocks: an application to banking systems

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  1. Financial networks and default-driven shocks: an application to banking systems Francisco Hawas(*) Research Assistant Mathematical Modeling CenterUniversidad de Chile (*) Joint project with Arturo Cifuentes and Alejandro Jofré

  2. Motivation • Financial crisis (2007-2008) • Size of banks? • Number of banks? • Degree of Interconnections? • Direct • Indirect • Regulatory and academic interest on the topic of financial networks

  3. Overview • Problems from the financial regulator viewpoint: • Liquidity risk • Inability to pay, not necessary a balance sheet problem • Solvency risk • Balance sheet problem • This project will focus, initially, on the solvency aspects • Liquidity will be left for a second stage

  4. Bank’s Balance sheet Assets Liabilities Cash, Ck Deposits, Dk Loans to third parties, Lk Debt to CB, Фk Loans to other banks, Bk Debts to other banks, Hk Deposits at CB, θ Dk Investments, Ik Equity, Ek

  5. Model Overview • Define balance sheet parameters: • , L, D, I, Ф, H, E, Θ • Define interconnection parameters • β, ρ • Direct connections between banks • : percentage of bank’s debt that bank owns • ; : number of banks • Indirect connections • : correlation through loans (L)

  6. Bank 1 Indirect connection Loans to third parties Gaussian Copula [ε, ρ] Bank N

  7. Model Overview • At time : • Simulate • : default loss • Gaussian Copula • Uniform marginals • Update • If bank has , then defaults • goes out of the simulation • Update • Loop until • Next period

  8. Model Overview End point: All Banks have defaulted End of simulation time Bank k such that will continue in the simulation

  9. Example • Parameters: • : 5% • : 30% • Θ: 0 • Equity ratio: 10% • All balance sheets are the same

  10. Example • Parameters: • : 5% • : 30% • Θ: 0 • Equity ratio: 8%-12% • All balance sheets are similar (Just Equity ratio differs)

  11. Topics to investigate • Influence of balance sheet structure • Leverage ratio • Central Bank policy • Effect of Θ • Rescue loan policy • Effects of number of banks • No diversification effects? • Effects of number of connections • Selection of counterparty is random

  12. Important questions to be answered • Does diversification improve system resilience? • Is interconnection (degree of) harmful for the financial system? • Importance of correlation at a fundamental level… important? • Is the dynamics of correlation important? • Steady, peak, steady, relevant? • What would be the effect of a run on a bank? Or the system? At which speed the system turn into unstable mode?

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