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Assessing systemic risk due to fire sales spillover through maximum entropy network reconstruction

Domenico Di Gangi, Fabrizio Lillo and Davide Pirino

Journal of Economic Dynamics and Control, 2018, vol. 94, issue C, 117-141

Abstract: Monitoring and assessing systemic risk in financial markets is of great importance but it often requires data that are unavailable or available at a very low frequency. For this reason, systemic risk assessment with partial information is potentially very useful for regulators and other stakeholders. In this paper we consider systemic risk due to fire sales spillovers and portfolio rebalancing by using the risk metrics defined by Greenwood et al. (2015). By using a method based on the constrained minimization of the Cross Entropy, we show that it is possible to assess aggregated and single bank’s systemicness and vulnerability, using only the information on the size of each bank and the capitalization of each investment asset. We also compare our approach with an alternative widespread application of the Maximum Entropy principle allowing to derive graph probability distributions and generating scenarios and we use it to propose a statistical test for a change in banks’ vulnerability to systemic events.

Keywords: Systemic risk; Maximum entropy; Fire sales; Financial networks; Liquidity (search for similar items in EconPapers)
JEL-codes: C45 C80 G01 G33 (search for similar items in EconPapers)
Date: 2018
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Journal of Economic Dynamics and Control is currently edited by J. Bullard, C. Chiarella, H. Dawid, C. H. Hommes, P. Klein and C. Otrok

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