Pathways towards instability in financial networks
Processes believed to stabilize financial markets can drive them towards instability by creating cyclical structures that amplify distress.
Following the financial crisis of 2007–2008, a deep analogy between the origins of instability in financial systems and complex ecosystems has been pointed out: in both cases, topological features of network structures influence how easily distress can spread within the system. However, in financial network models, the details of how financial institutions interact typically play a decisive role, and a general understanding of precisely how network topology creates instability remains lacking. Here we show how processes that are widely believed to stabilize the financial system, that is, market integration and diversification, can actually drive it towards instability, as they contribute to create cyclical structures which tend to amplify financial distress, thereby undermining systemic stability and making large crises more likely. This result holds irrespective of the details of how institutions interact, showing that policy-relevant analysis of the factors affecting financial stability can be carried out while abstracting away from such details.
More in Reconstructing credit networks
Statistical physics contributes to new models and metrics for the study of financial network structure, dynamics, stability and instability.
Consistent valuation of interbank claims within an interconnected financial system can be found with a recursive update of banks' equities.
New mathematical tools can help infer financial networks from partial data to understand the propagation of distress through the network.
Network-based metrics to assess systemic risk and the importance of financial institutions can help tame the financial derivatives market.
Time series data from networks of credit default swaps display no early warnings of financial crises without additional macroeconomic indicators.
Statistical mechanics concepts reconstruct connections between financial institutions and the stock market, despite limited data disclosure.