Unraveling Systemic Risk Transmission: An Empirical Exploration of Network Dynamics and Market Liquidity in the Financial Sector

The banking industry, as a cornerstone of the economy, plays a pivotal role in the efficient allocation of funds. However, it is not immune to the peril of systemic risk, a threat that can trigger a domino effect, jeopardizing the entire financial system. This research paper delves into the complexities of systemic risk within the banking sector, focusing on the transmission mechanisms through interbank networks and market liquidity. By conducting an empirical analysis based on the 2011 EU-wide stress test, the study reveals the significant roles that network and market liquidity channels play in the dissemination of systemic risk. The paper highlights how the market liquidity channel potentially has a more substantial impact on contagion compared to the network channel, challenging pre-existing beliefs that have predominantly emphasized network structures in systemic risk propagation. The study meticulously analyzes the interplay between financial institutions, interbank lending, borrowing, and the impacts of leverage and market liquidity, offering a comprehensive view of the systemic risk landscape in banking. It provides insights into the complexities of risk dynamics, leveraging the methodology proposed by Chen et al. (Oper. Res. 64(5):1089–1108, 2016) for a detailed balance sheet examination and network modeling. The findings underscore the importance of understanding and controlling risk channels, notably the network and market liquidity channels, to maintain the stability and resilience of the banking system. Policy implications are profound, suggesting that regulators and policymakers need to focus on enhancing market liquidity during economic strains and adopt targeted regulatory approaches to mitigate vulnerabilities stemming from interconnectedness and leverage. The study also emphasizes the need for ongoing monitoring and proactive management of systemic risk channels, recommending regular stress tests and the development of flexible regulatory measures that adapt to changing systemic risk factors. This research contributes significantly to the ongoing discussion on systemic risk in the financial sector, filling gaps in the literature by integrating various elements like network topologies and market liquidity in a comprehensive framework. It provides a novel perspective on the complex relationship between network interconnectedness and liquidity dynamics and offers practical guidance for optimizing banking structures for enhanced efficiency and resilience.