Cascades in financial networks

Cascades in financial networks are situations in which the failure of one financial institution causes a cascading failure in another member of the financial network. In an extreme this can cause failure of the whole network in what is known as systemic failure. It can be defined as the discontinuous value loss (e.g. default) of the organization caused by the discontinuous value loss of another organization in the network.

There are three conditions required for a cascade, there are; a failure, contagion and interconnection.[1]

Diversification and integration in the financial network determine whether and how failures will spread. Using the data on cross-holdings of organizations and on the value of organizations, it is possible to construct the dependency matrix to simulate cascades in the financial network.

Diversification and Integration

Elliot, Golub and Jackson (2013) characterize the financial network by diversification and integration. Diversification means to which extent assets of the one organization are spread out among the other members of the network, given the fraction of the assets of the organization cross-held by other organizations is fixed. Integration refers to the fraction of the assets of the organization cross-held by other organizations given the number of the organizations cross-holding is fixed.

Using random network, the authors [2] show that high integration decreases the percentage of first failures; and as the network approaches complete integration the percentage of the first failures approaches zero. However, the integration increases the percentage of organizations that fail due to higher interconnection. In addition, up to some threshold, diversification does increase the percentage of discontinuous drops in value. Yet after the threshold level, the diversification decreases the percentage of failures: the authors say the following with respect to diversification: “it gets worse before it gets better”.[3]

Intuitively, the higher the threshold value for the discontinuous drop in the organization’s value the higher the percentage of failures is.

The authors [4] conclude that the financial network is most susceptible to cascades if it has medium diversification and medium integration.

References

  1. ^Elliott, M., Golub, B. and Jackson 2013. M Financial Networks and Contagion http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2175056 http://www.its.caltech.edu/~melliott/papers/financial_networks.pdf
  2. ^Elliott, M., Golub, B. and Jackson 2013. M Financial Networks and Contagion http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2175056
  3. ^Elliott, M., Golub, B. and Jackson 2013. M Financial Networks and Contagion20 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2175056
  4. ^Elliott, M., Golub, B. and Jackson 2013. M Financial Networks and Contagion http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2175056
  5. ^Brioschi, F., Buzzachi, Land Colombo, M.M. 1989. “Risk Capital Financing and the Separation of Ownership and Control in Business Groups,” Journal of Banking and Finance, 13, 742-772
  6. ^Fedina, M., Hodder J.E. and Trianitis A.J. 1994. “Cross Holdings Estimation Issues, Biases, and Distorntions,” The Review of Financial Studies, 7, 61-69

 

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