November

Financial networks and systemic collapse

By Edoardo Gallo, CERF Fellow

In the aftermath of the 2008 crisis, Haldane – the Chief Economist at the Bank of England – stated that “the regulation of the network is needed to ensure appropriate control of large, interconnected institutions […] the financial network should be structured so as to reduce the chances of future systemic collapse”.

A project by CERF Fellow Edoardo Gallo and his research collaborators Syngjoo Choi (Seoul National University) and Brian Wallace (UCL) investigates what type of network structures cause financial contagion. In a lab experiment, participants can buy or sell assets in an artificial market knowing that one participant has been hit by a monetary shock and there is a possibility that it may spill over to others because all participants are connected by a network of liabilities. Each participant faces a trade-off between selling to raise liquidity in the short term to avoid bankruptcy or hold on to assets to realize a return in the long-term. The researchers vary the network of liabilities and the size of shocks.

The results show that contagion is particularly prevalent in core-periphery networks formed by a small number of highly connected participants – the core – and with the remaining participants at the sparsely connected periphery. The dynamics of contagion involves sharp falls in the price of assets because all participants are trying to sell to raise liquidity, and this leads to systemic collapse even for moderately sized shocks.  The researchers find evidence that a participant’s ability to comprehend the network-driven risk is predictive of how likely they are to go bankrupt. 

Core-periphery networks are ubiquitous in financial markets, and the results of this project suggest they may be particularly susceptible to systemic collapse.

The paper is available here.