Modelling risk sharing and impact on systemic risk

Walter Farkas and Patrick Lucescu
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Walter Farkas: University of Zurich - Department Finance; Swiss Finance Institute; ETH Zürich
Patrick Lucescu: University of Zurich - Department of Finance

No 24-32, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: This paper develops a simplified agent-based model to investigate the dynamics of risk transfer and its implications for systemic risk within financial networks, focusing specifically on Credit Default Swaps (CDSs) as instruments of risk allocation among banks and firms. Unlike broader models that incorporate multiple types of economic agents, our approach explicitly targets the interactions between banks and firms across three markets: credit, interbank loans, and CDSs. This model diverges from the frameworks established by Leduc, Poledna, and Thurner (2016) and Poledna and Thurner (2016) by simplifying the agent structure, which allows for more focused calibration to empirical data—specifically, a sample of Swiss banks—and enhances interpretability for regulatory use. Our analysis centers around two control variables, CDSc and CDSn, which modulate the likelihood of institutions participating in covered and naked CDS transactions, respectively. This approach allows us to explore the network’s behavior under varying levels of interconnectedness and differing magnitudes of deposit shocks. Our results indicate that the network can withstand minor shocks, but higher levels of CDS engagement significantly increase variance and kurtosis in equity returns, signaling heightened instability. This effect is amplified during severe shocks, suggesting that CDSs, instead of mitigating risk, propagate systemic risk, particularly in highly interconnected networks. These findings underscore the need for regulatory oversight to manage risk concentration and ensure financial stability.

Keywords: Systemic Risk; Agent-Based Modeling; Financial Networks; Risk Transfer; Network Interconnectedness; Credit Default Swaps (search for similar items in EconPapers)
JEL-codes: C63 D85 G01 G21 (search for similar items in EconPapers)
Pages: 22 pages
Date: 2024-05
New Economics Papers: this item is included in nep-ban, nep-hme, nep-net and nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp2432

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