Network versus portfolio structure in financial systems

Teruyoshi Kobayashi

No 1307, Discussion Papers from Graduate School of Economics, Kobe University

Abstract: The question of how to stabilize financial systems has attracted considerable attention since the global financial crisis of 2007-2009. Recently, Beal et al. ( gIndividual versus systemic risk and the regulator's dilemma h, Proc Natl Acad Sci USA 108: 12647-12652, 2011) demonstrated that higher portfolio diversity among banks would reduce systemic risk by decreasing the risk of simultaneous defaults at the expense of a higher likelihood of individual defaults. In practice, however, a bank default has an externality in that it undermines other banks' balance sheets. This paper explores how each of these different sources of risk, simultaneity risk and externality, contributes to systemic risk. The results show that the allocation of external assets that minimizes systemic risk varies with the topology of the financial network as long as asset returns have negative correlations. In the model, a well-known centrality measure, PageRank, reflects an appropriately defined ginfectiveness h of a bank. An important result is that the most infective bank need not always be the safest bank. Under certain circumstances, the most infective node should act as a firewall to prevent large collective defaults. The introduction of a counteractive portfolio structure will significantly reduce systemic risk.

Keywords: Systemic risk; financial crisis; financial network; macro-prudential policy (search for similar items in EconPapers)
JEL-codes: G18 (search for similar items in EconPapers)
Pages: 29pages
Date: 2013-04
New Economics Papers: this item is included in nep-ban, nep-net and nep-rmg
References: View complete reference list from CitEc
Citations: View citations in EconPapers (13)

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