Risk contagion in the banking network: New evidence from China

Based on data from 111 Chinese banks over the 2013–2016 period, this paper estimates the interbank bilateral lending matrix using the maximum entropy method. The estimated matrix is used to simulate the effects of credit and liquidity shocks on China’s banking network. Simulation results show that, under the extreme pressure scenario, the contagion arising from a liquidity shock is significantly stronger than the effect of a credit shock, indicating the importance of liquidity in the banking system. The contagion effect arising from a credit shock does not vary much over the sample period. However, the contagion effect arising from a liquidity shock decreases significantly, which could be attributed to contraction in interbank business due to stricter interbank business supervision. The simulation results also identify the most important and most vulnerable nodes of the banking system. An increase in the level of capital level can enhance the ability of banks to withstand credit and liquidity shocks. Our analysis also suggests that risk contagion faced by China’s banks varies across banking network structures.     

Robustness of banking networks to idiosyncratic and systemic shocks: a network-based approach

We propose a network-based structural model of credit risk to demonstrate how idiosyncratic and systemic shocks propagate across the banking system and evaluate the costs. The banking system is built as a network of heterogeneous banks which are connected with one another. In such a system, single credit events propagate through the interbank market from debtors to creditors and across the system. The shock is imposed as an unexpected event. We demonstrate that while idiosyncratic shocks cannot substantially disturb the banking system, a systemic shock of even a moderate magnitude can be highly detrimental. Such shock includes a huge contagious potential. We demonstrate that the costs of the shock are largely determined by the extent of contagion and range from negligible to catastrophic. The results imply that a severe crisis has to be initiated by a systemic shock of at least moderate magnitude. Capital ratio and the bank size are two additional factors of the banking system stability. Finally, credit risk analysis is sensitive to the network topology and exhibits a profound nonlinear characteristic.     

Portfolio diversification and systemic risk in interbank networks

This paper contributes to a growing literature on the ambiguous effects of risk diversification. In our model, banks hold claims on each other’s liabilities that are marked-to-market on the individual financial leverage of the obligor. The probability of systemic default is determined using a passage-problem approach in a network context and banks are able to internalize the network externalities of contagion through their holdings. Banks do not internalize the social costs to the real economy of a systemic default of the banking system. We investigate the optimal diversification strategy of banks in the face of opposite and persistent economic trends that are ex-ante unknown to banks. We find that the optimal level of risk diversification may be interior or extremal depending on banks exposure the external assets and that a tension arises whereby individual incentives favor a banking system that is over-diversified with respect to the level of diversification that is desirable in the social optimum.     

Systemic risk mitigation in financial networks

We propose a multi-period clearing framework, where the level of systemic risk is mitigated through the provision of liquidity assistance. The interbank liability network evolves stochastically over time, and assets of defaulted banks are sold to qualified banks within the network through a first-price sealed-bid auction. We find that policies targeting systemically important banks are more effective in core-periphery network structures, whereas those maximizing the total liquidity in the system are preferred in random network configurations. We assess sensitivity of systemic risk to variations in interbank liabilities as well as to their correlation structure.     

Systemic risk in banking networks: Advantages of “tiered” banking systems

This paper studies the risk and potential impact of system-wide defaults in a tiered banking network, where a small group of head institutions has many credit linkages with other banks, while the majority of banks have only a few links. A network is random and displays a given distribution of the number of banks׳ linkages, known as degree. We model tiering by a negative correlation between degrees of neighboring banks and by a scale-free degree distribution. The main findings of the paper highlight the advantages of tiering. Both the risk of systemic crisis and the potential scope of the crisis are lower in systems with negative correlation of bank degrees than in other types of systems. Similarly, in scale-free networks, the resilience of the system to shocks is increasing with the level of tiering.     

Topological properties of reconstructed credit networks and banking systemic risk

Financial bipartite networks provide channels for contagion risks and their topological properties determine financial stability. We enrich the bipartite network reconstruction methods proposed by Ramadiah et al. (2020) and extend them to the Chinese banking system. By comparing the reproducibility of the real credit market and the corresponding systemic risk, the impact of topological properties for different reconstructed bipartite networks on financial stability is analyzed. The empirical evidence shows that network reconstruction methods based on maximum entropy ensembles capture more properties in the real credit network. It also highlights that the different systemic risk level is mainly contributed by the topological properties based on common exposures. These analyses for topological properties provide regulatory insights for systemic risk prevention. It shows that reducing credit similarity across banks while increasing credit diversification in different sectors helps to control systemic risk. The results imply the possibility of increasing financial stability through the macro-regulation of the credit market structure.     

Overlapping portfolios,contagion, and financial stability

We study the problem of interacting channels of contagion in financial networks. The first channel of contagion is counterparty failure risk; this is captured empirically using data for the Austrian interbank network. The second channel of contagion is overlapping portfolio exposures; this is studied using a stylized model. We perform stress tests according to different protocols. For the parameters we study neither channel of contagion results in large effects on its own. In contrast, when both channels are active at once, bankruptcies are much more common and have large systemic effects.     

Benchmarking,knowledge inertia,and knowledge performance in different network structures

ABSTRACT

A simulation approach is employed to examine the relationship between benchmarking and OKP, and how knowledge inertia in benchmarking influences OKP in different network structures. Results suggest that quick benchmarking (low knowledge inertia) and moderate mutual learning produce higher short-term OKP. Slow benchmarking (high knowledge inertia) and moderate mutual learning achieve higher long-term OKP. OKP performs better in scale-free networks than in small-world networks in the short period. However, in the long period, OKP is higher in small-world networks. Findings guide managers’ efforts in choosing the most suitable benchmarking and also suggest that managers should not ignore knowledge inertia.     

Does diversification promote systemic risk?

We measure systemic risk when faced with simulated shocks through the systemic model of banking originated losses. The formation mechanism of systemic risk is explored from the perspective of investment diversification and asset similarity. The results indicate that contagion risks formed by the over similarity of investment assets are the main cause of systemic risk. The similarity generally promotes contagion risks, however, it shows a double-faced effect for state-owned commercial banks that disperse shocks from counterparties through their too-big-to-fail advantages. The similarity is determined by diversification, which initially promotes similarity and disperses it after a threshold. The diversification acts on the contagion process of systemic risk by the mediation of the similarity. Therefore, diversification generally has a nonlinear impact on systemic risk. The results provide regulatory implications for the systemic stability of the banking system.     

Limitations of portfolio diversification through fat tails of the return Distributions: Some empirical evidence

This study investigates the level of risk due to fat tails of the return distribution and the changes of tail fatness (TF) through portfolio diversification. TF is not eliminated through portfolio diversification, and, interestingly, the positive tail has declining fatness until a certain level is reached, while the negative tail has rising fatness. This indicates that fat tails are highly relevant to common factors on systematic risk and that the relevance of common factors is higher for the negative tail compared to the positive tail. In the portfolio diversification effect, the declining fatness of the positive tail further reduces risk, but the rising fatness of the negative tail does not contribute to this effect. The asymmetry between the fatness of the positive and negative tails in the return distribution corresponds to the asymmetry of the trade-off relationship between loss avoidance and profit sacrifice that is expected as a consequence of portfolio diversification. Investors use portfolio diversification to reduce their risk of suffering high losses, but following this strategy means sacrificing high-profit potential. Our study provides empirical confirmation for the practical limitation of portfolio diversification and explains why investors with diversified portfolios suffer high losses from market crashes. An examination of the Northeast Asian stock markets of China, Japan, Korea, and Taiwan show identical results.     

An empirical study of the Mexican banking system’s network and its implications for systemic risk

With the aim to measure and monitor systemic risk, we present some topological metrics for the interbank exposures and the payments system networks. The evolution of such networks is analyzed, we draw important conclusions from the systemic risk's perspective and propose a measure of interconnectedness. Additionally, we suggest non-topological measures to describe individual behavior of banks in both networks. The main findings of this paper are: the structures of the payments and exposures networks are different (in terms of connectivity); the topology of the exposures network changed after the collapse of Lehman Brothers, whereas the structure of the payments network does not; the proposed measure of interconnectedness can be used to determine the importance of a bank in terms of connectivity. Finally, we found that interconnectedness of a bank is not necessarily related with its assets size but it is linked to the contagion it might cause.     

Spillovers and diversification potential of bank equity returns from developed and emerging America

We examine the network spillovers, portfolio allocation characteristics and diversification potential of bank returns from developed and emerging America. We draw our results by applying a directional spillover index, the tail-event driven network (TENET) and nonlinear portfolio optimization methods on bank returns. We find that the spillovers and connectedness among banks from emerging America are noticeably smaller than those among banks from developed America. The largest emerging market spillover transmitters and receivers are the banks from Brazil, followed by the banks from Chile. The largest developed market spillover transmitter is JP Morgan Chase. The connectedness among banks from developed America is dominated by the banks from the USA, relative to those from Canada. The total connectedness of the emerging market banks is more intensified than that of the banks from developed America due to the effect of the COVID-19 pandemic. The portfolio optimization shows that in developed America, the largest banks from the USA are the largest risk contributors to total portfolio risk, whereas the banks from Canada contribute the least risk. In emerging America, the banks from Brazil contribute the most risk to total portfolio risk while the banks from Peru and one bank from Colombia contribute the least risk. The portfolio of banks from emerging America offers greater diversification potential and lower total portfolio allocation risk.     

Locational concentration and institutional diversification: Evidence from foreign direct investments in the banking industry

We study locational concentration and institutional diversification strategies in the context of foreign direct investment based on Dunning’s eclectic paradigm in the banking industry. We report that locational concentration and institutional diversification strategies can enhance multinational bank return independently and simultaneously. Further, we document that locational concentration increases operational risk, while an institutional diversification strategy reduces this risk for a multinational bank. Our findings suggest that even when concentrating in a limited number of geographic locations, it is preferable to select more institutionally dissimilar countries. Overall, we conclude that multinational banks can achieve better performance by focusing on either locational concentration or institutional diversification, or a combination of both.     

Contagion risk in the Czech financial system: A network analysis and simulation approach

This paper examines the potential for contagion within the Czech banking system via the channel of interbank exposures of domestic banks, enriched by a liquidity channel and an asset price channel, over the period March 2007 to June 2012. A computational model is used to assess the resilience of the Czech banking system to interbank contagion, taking into account the size and structure of interbank exposures as well as balance sheet and regulatory characteristics of individual banks in the network. The simulation results suggest that the potential for contagion due to credit losses on interbank exposures was rather limited. Even after the introduction of a liquidity condition into the simulations, the average contagion was below 3.8% of the remaining banking sector assets, with the exception of the period from December 2007 to September 2008. Activation of the asset price channel further increases the losses due to interbank contagion, showing that the liquidity of government bonds would be essential for the stability of Czech banks in stress situations. Finally, the simulation results for both idiosyncratic and multiple bank failure shocks suggest that the potential for contagion in the Czech banking system has decreased since the onset of the global financial crisis.     

Agency costs in the banking industry: An examination of ownership behavior,leverage and dividend policies

This paper examines agency theory arguments in the banking industry by analyzing the effect of four variables that proxy for agency costs—earnings volatility, managers' portfolio diversification losses, bank size, and standard deviation of bank equity returns—on the three financial policy variables of managerial stock ownership, leverage, and dividend yield. It is one of the first studies that examines the determination of financial policy variables, in light of agency concerns, in the banking industry. The study examines the largest 104 U.S. banks during the period 1985–1989. Evidence suggests that bank size and a measure of the managers' portfolio diversification opportunity set affect the bank's level of managerial stock ownership, leverage and dividends.     

Incentivizing resilience in financial networks

When banks extend loans to each other, they generate a negative externality in the form of systemic risk. They create a network of interbank exposures by which they expose other banks to potential insolvency cascades. In this paper, we show how a regulator can use information about the financial network to devise a transaction-specific tax based on a network centrality measure that captures systemic importance. Since different transactions have different impact on creating systemic risk, they are taxed differently. We call this tax a systemic risk tax (SRT). We use an equilibrium concept inspired by the matching markets literature to show analytically that this SRT induces a unique equilibrium matching of lenders and borrowers that is systemic-risk efficient, i.e. it minimizes systemic risk given a certain transaction volume. On the other hand, we show that without this SRT multiple equilibrium matchings exist, which are generally inefficient. This allows the regulator to effectively stimulate a ‘rewiring’ of the equilibrium interbank network so as to make it more resilient to insolvency cascades, without sacrificing transaction volume. Moreover, we show that a standard financial transaction tax (e.g. a Tobin-like tax) has no impact on reshaping the equilibrium financial network because it taxes all transactions indiscriminately. A Tobin-like tax is indeed shown to have a limited effect on reducing systemic risk while it decreases transaction volume.     

Lessons from naïve diversification about the risk-reward trade-off

Studies of naïve diversification show that average total portfolio risk declines asymptotically as number of stocks increases. Recent work shows that a significant amount of idiosyncratic risk remains, even for portfolios with large numbers of stocks. The corresponding shocks are non-trivial. For example, more than half of all equal-weighted portfolios with 100 stocks have better than a 16 percent chance of an annual shock at least as large as about half of the annualized mean excess return on the U.S. total stock market index over July 1963–June 2018. I perform a simulation analysis of portfolio reward-to-risk as well as the components of total portfolio risk. On average, investors do not appear to be rewarded for exposure to non-systematic risk. The cross-sectional distribution of the true Sharpe ratio rises and its dispersion shrinks significantly as the number of stocks in the portfolio increases, whereas the cross-sectional distribution of the true non-systematic risk falls and its dispersion shrinks significantly as the number of stocks in the portfolio increases. This pattern appears regardless of the true asset pricing model for generating security returns, the portfolio weighting method, or specification of security alphas.     

Does the bank risk concentration freeze the interbank system?

Probably, one test of the stability of the banking system is to evaluate how risky assets are distributed across banks’ portfolios and the implications for the contagion via interbank relations. This paper explores theoretically a bank sector with risks concentration and the functioning of interbank markets. It employs a simple model where banks are exposed to both credit and liquidity risk that suddenly correlate over the business cycle. We show that risk concentration makes interbank market breakdowns more likely and welfare monotonically decreases in risk concentration.     

An agent-based model of innovation diffusion: network structure and coexistence under different information regimes

The paper analyzes how the structure of social networks affects innovation diffusion and competition under different information regimes. Diffusion is modeled as the result of idiosyncratic adoption thresholds, local network effects and information diffusion (broadcasting and demonstration effect from previous adopters). A high social cohesion decreases the probability of one innovation cornering the market. Nonetheless, with imperfect information, in small-world networks the higher speed of diffusion produced by the low average distance increases this probability. A low social cohesion also increases the probability of falling into traps of under-adoption. However, such probability is significantly lower with imperfect information, because such regime is characterized by higher levels of market concentrations and this reduces the frictions due to the coexistence of non-compatible product innovations.     

The double-edged sword effect of diversified operation on pre- and post-loan risk in the government-led Chinese commercial banks

Under the background of China’s deregulation of financial institutions since 2004, Chinese commercial banks have undergone remarkable change from traditional lending activities to universal fee-based activities. This paper explores the effect of diversified operation on bank credit activities. We find that diversification can reduce pre-loan risk but increase post-loan risk. Besides, enhanced disclosure requirement of other comprehensive income can mitigate pre- and post-loan risk under diversified operation. Additionally, in the state-owned commercial banks where government function is primary, diversification reduces both pre- and post-loan risk. This paper aims to reveal the double-edged sword effect of diversification in the Chinese commercial banks which are more government-led.