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The price of complexity in financial networks

Increasing the complexity of the network of contracts between financial institutions decreases the accuracy of estimating systemic risk.

Proceedings of the National Academy of Sciences 113, 36 (2016)

S. Battiston, G. Caldarelli, R. May, T. Roukny, J. Stiglitz

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• Arxiv

Financial institutions form multilayer networks by engaging in contracts with each other and by holding exposures to common assets. As a result, the default probability of one institution de- pends on the default probability of all of the other institutions in the network. Here, we show how small errors on the knowledge of the network of contracts can lead to large errors in the probability of systemic defaults. From the point of view of financial regulators, our findings show that the complexity of financial networks may de- crease the ability to mitigate systemic risk, and thus it may increase the social cost of financial crises.