BoE paper seeks origin of systemic risk

Network analysis can create a clearer picture of how systemic risk emerges from banks’ interactions with one another, research published by the Bank of England finds.

Mattia Montagna, Gabriele Torri and Giovanni Covi say the issue of systemic risk is critical to the work of central banks but remains “difficult to measure and quantify”. Time series methods struggle to capture risks, they say, partly because the series are “highly correlated and non-stationary”, and partly because there is limited data on financial crises.

Instead, On the origin of systemic risk outlines a multi-layer network model that aims to capture the microstructure of bank balance sheets. This approach allows the researchers to explore the entanglement of bank balance sheets and banks’ vulnerability to various contagion mechanisms. This enables the researchers to estimate the likelihood of multiple defaults.

The authors calibrate their model using an exposure-level dataset of eurozone banks. Based on this, they estimate that 45.8% of systemic risk in the European financial sector is driven by correlated economic shocks. A further 44.8% comes from three contagion channels – solvency, liquidity and fire sales, they calculate, while economic credit risk accounts for 8.7%.

The authors say their model could be used as a tool by regulators and central banks to study developments in systemic risk.