Size and complexity in model financial systems
AbstractThe global financial crisis has precipitated an increasing appreciation of the need for a systemic perspective towards financial stability. For example: What role do large banks play in systemic risk? How should capital adequacy standards recognize this role? How is stability shaped by concentration and diversification in the financial system? We explore these questions using a deliberately simplified, dynamical model of a banking system which combines three different channels for direct spillovers from one bank to another: liquidity hoarding, asset price contagion, and the propagation of defaults via counterparty credit risk. Importantly, we also introduce a mechanism for capturing how swings in ‘confidence’ in the system may contribute to instability. Our results highlight that the importance of relatively large, well-connected banks in system stability scales more than proportionately with their size: the impact of their collapse arises not only from their connectivity, but also from their effect on confidence in the system. Imposing tougher capital requirements on larger banks than smaller ones can thus enhance the resilience of the system. Moreover, these effects are more pronounced in more concentrated systems, and continue to apply even when allowing for potential diversification benefits which may be realised by larger banks. We discuss some tentative implications for policy, as well as conceptual analogies in ecosystem stability, and in the control of infectious diseases.
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Bibliographic InfoPaper provided by Bank of England in its series Bank of England working papers with number 465.
Length: 37 pages
Date of creation: 07 Oct 2012
Date of revision:
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Systemic risk; financial crises; contagion; network models; liquidity risk; confidence;
Find related papers by JEL classification:
- D85 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Network Formation
- G01 - Financial Economics - - General - - - Financial Crises
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
This paper has been announced in the following NEP Reports:
- NEP-ALL-2012-10-13 (All new papers)
- NEP-BAN-2012-10-13 (Banking)
- NEP-CBA-2012-10-13 (Central Banking)
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