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Structure of the Financial System and the Contagion Effect: A Network Approach

Author

Listed:
  • Mariko Fujii

    (RCAST, The University of Tokyo)

  • Makoto Takaoka

    (Faculty of Law and Letters, University of the Ryukyus)

Abstract

In this paper, the financial system is modeled as a network in order to explore the factors that affect its robustness. We then discuss policy implications for effective financial regulations through network simulation exercises. Specifically, we focus on the contagion mechanism of exogenous shocks within the financial sector and discuss how recent trends such as the rapid expansion of financial intermediation heavily dependent on wholesale funding and growing interconnectedness among financial institutions would affect the stability of the financial system. Our simulation results based on the scale-free network model show the following: (1) the expansion of financial intermediation heavily dependent on wholesale funding probably makes the system more vulnerable, while increased interconnectedness does not necessarily enhance the contagion effect. (2) A higher capital adequacy ratio may provide more resilience against exogenous shocks; however, it will have a diminishing effect. (3) Depending on the structure of the financial system, the risk of contagions cannot be ruled out when assets at multiple financial institutions are impaired concurrently, even if these institutions are not large. The following implications for financial regulation can be obtained from the above analysis: (1) a macro-prudential point of view is essential for monitoring the common exposures, (2) dependency on wholesale funding should be limited, (3) it is worthwhile to consider new indicators that supplement the capital adequacy ratio in order to design a new combination of the regulatory measures that take into account the characteristics and vulnerabilities of financial networks. For a more practical analysis as a rigorous basis for financial regulation, it is critically important to accumulate and analyze data describing the financial network structure.

Suggested Citation

  • Mariko Fujii & Makoto Takaoka, 2011. "Structure of the Financial System and the Contagion Effect: A Network Approach," Public Policy Review, Policy Research Institute, Ministry of Finance Japan, vol. 7(1), pages 27-50, June.
  • Handle: RePEc:mof:journl:ppr013b
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    File URL: http://warp.ndl.go.jp/info:ndljp/pid/10248500/www.mof.go.jp/english/pri/publication/pp_review/ppr013/ppr013b.pdf
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    More about this item

    Keywords

    Scale-free Network; Capital Adequacy Ratio; Interconnectedness; Contagion Effects;
    All these keywords.

    JEL classification:

    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • G01 - Financial Economics - - General - - - Financial Crises
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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