Systemic Risk: The Dynamics of Modern Financial Systems by Prasanna Gai

By Prasanna Gai

This booklet opens new floor within the learn of economic crises. It treats the economy as a fancy adaptive process and exhibits how classes from community disciplines - corresponding to ecology, epidemiology, and statistical mechanics - make clear our knowing of economic balance. utilizing instruments from community thought and economics, it means that monetary structures are robust-yet-fragile, with knife-edge houses which are tremendously exacerbated through the hoarding of money and the fireplace sale of resources via banks. The e-book experiences the dangerous community effects of the failure of huge inter-connected associations, explains how key investment markets can grab up around the complete economy, and indicates how the pursuit of secured finance by way of banks within the wake of the worldwide monetary challenge can generate systemic dangers. The insights are then used to version banking structures calibrated to information to demonstrate how monetary area regulators are starting to quantify economic system rigidity.

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The role that central clearing houses can play in dealing with issues of concentration and connectivity is also considered in light of the model. 1 Balance sheets and the liquidity condition As in Chapter 2, the financial network consists of n financial intermediaries, banks for short, linked together by their unsecured claims on each other. Banks in the network are represented by nodes and the links between them are directed, reflecting the assets and liabilities on their balance sheets. Since every unsecured interbank asset of a bank is an unsecured liability of another, every outgoing link for one node is an incoming link for another node.

By contrast, when the network is incomplete, with banks only having exposures to a few counterparties, the system is more fragile. The initial impact of a shock is concentrated among neighbouring banks. Once these succumb, the premature liquidation of long-term assets and the associated loss of value bring previously unaffected banks into the firing line. Freixas et al. (2000) show that tiered systems with money-centre banks, where banks on the periphery are linked to the centre but not to each other, may also be susceptible to contagion.

In what follows, the secured financing market becomes a key channel of contagion as banks hoard rather than lend liquidity when haircuts rise. The analysis of this chapter takes into account two further characteristics of the international financial system leading up to the crisis—its complexity and concentration. Pre-crisis, financial intermediaries entered into secured financing transactions with one another, inflating balance sheets in the process. 4 Financial system complexity goes hand-in-hand with such intrafinancial activity, particularly when the same security is used repeatedly as collateral in repo lending activity.

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