Size and complexity in model financial systems

Nimalan Arinaminpathy (), Sujit Kapadia and Robert May ()
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Nimalan Arinaminpathy: Princeton University
Robert May: Oxford University

No 465, Bank of England working papers from Bank of England

Abstract: The global financial crisis has precipitated an increasing appreciation of the need for a systemic perspective towards financial stability. For example: What role do large banks play in systemic risk? How should capital adequacy standards recognize this role? How is stability shaped by concentration and diversification in the financial system? We explore these questions using a deliberately simplified, dynamical model of a banking system which combines three different channels for direct spillovers from one bank to another: liquidity hoarding, asset price contagion, and the propagation of defaults via counterparty credit risk. Importantly, we also introduce a mechanism for capturing how swings in ‘confidence’ in the system may contribute to instability. Our results highlight that the importance of relatively large, well-connected banks in system stability scales more than proportionately with their size: the impact of their collapse arises not only from their connectivity, but also from their effect on confidence in the system. Imposing tougher capital requirements on larger banks than smaller ones can thus enhance the resilience of the system. Moreover, these effects are more pronounced in more concentrated systems, and continue to apply even when allowing for potential diversification benefits which may be realised by larger banks. We discuss some tentative implications for policy, as well as conceptual analogies in ecosystem stability, and in the control of infectious diseases.

Keywords: Systemic risk; financial crises; contagion; network models; liquidity risk; confidence (search for similar items in EconPapers)
JEL-codes: D85 G01 G21 G28 (search for similar items in EconPapers)
Pages: 37 pages
Date: 2012-10-07
New Economics Papers: this item is included in nep-ban and nep-cba
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (69)

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Persistent link: https://EconPapers.repec.org/RePEc:boe:boeewp:0465

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