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The Effect of Heterogeneity on Financial Contagion Due to Overlapping Portfolios

Banwo, O; Caccioli, F; Harrald, P; Medda, F; (2017) The Effect of Heterogeneity on Financial Contagion Due to Overlapping Portfolios. Advances in Complex Systems , 19 , Article 1650016. 10.1142/S0219525916500168. Green open access

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Abstract

We consider a model of financial contagion in a bipartite network of assets and banks recently introduced in the literature, and we study the effect of power law distributions of degree and balance-sheet size on the stability of the system. Relative to the benchmark case of banks with homogeneous degrees and balance-sheet sizes, we find that if banks have a power law degree distribution the system becomes less robust with respect to the initial failure of a random bank, and that targeted shocks to the most specialized banks (i.e., banks with low degrees) or biggest banks increases the probability of observing a cascade of defaults. In contrast, we find that a power law degree distribution for assets increases stability with respect to random shocks, but not with respect to targeted shocks. We also study how allocations of capital buffers between banks affects the system’s stability, and we find that assigning capital to banks in relation to their level of diversification reduces the probability of observing cascades of defaults relative to size-based allocations. Finally, we propose a non-capital-based policy that improves the resilience of the system by introducing disassortative mixing between banks and assets.

Type: Article
Title: The Effect of Heterogeneity on Financial Contagion Due to Overlapping Portfolios
Open access status: An open access version is available from UCL Discovery
DOI: 10.1142/S0219525916500168
Publisher version: http://dx.doi.org/10.1142/S0219525916500168
Language: English
Additional information: Electronic version of an article published as Banwo, O; Caccioli, F; Harrald, P; Medda, F; (2017) The Effect of Heterogeneity on Financial Contagion Due to Overlapping Portfolios. Advances in Complex Systems, Article 1650016, doi:10.1142/S0219525916500168, copyright © World Scientific Publishing Company 2017: http://www.worldscientific.com/worldscinet/acs
Keywords: Contagion; systemic risk; network models
UCL classification: UCL > Provost and Vice Provost Offices
UCL > Provost and Vice Provost Offices > UCL BEAMS
UCL > Provost and Vice Provost Offices > UCL BEAMS > Faculty of Engineering Science
UCL > Provost and Vice Provost Offices > UCL BEAMS > Faculty of Engineering Science > Dept of Civil, Environ and Geomatic Eng
UCL > Provost and Vice Provost Offices > UCL BEAMS > Faculty of Engineering Science > Dept of Computer Science
URI: http://discovery.ucl.ac.uk/id/eprint/1538987
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