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Networks, subnetworks and macroprudential capital requirements

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Systemic Risk: Mathematical Modelling and Interdisciplinary Approaches

Co-author: Jukka Isohtl (Loughborouh University and University of Oulu)

This paper explores some of the consequences of network asymmetry for the transmission and containment of systemic financial risk. Before the global financial crisis network linkage was regarded as a source of stability, providing valuable diversification benefits to the most widely connected firms; since the crisis network linkages this view is widely questioned, is connectivity not a source of vulnerability and of potential transmission of systemic events? A related question is whether macroprudential capital requirements, set to protect the financial system against such systemic events, are better framed (for any given level of aggregate required capital) so as EITHER minimize the degree of transmission of shocks across the system i.e. focussed on the most connected firms; OR to maximize the ability of individual firms to withstand systemic disturbances i.e. focussed on the most specialized firms. These questions (connectivity as a source of protection or source of risk? f ocussing capital on connected or exposed firms) are only meaningful once allowance is made for network asymmetry and the presence of sub-networks (local connections and exposures within the financial system). We seek answers to these questions through simulation of a simple model of systemic financial risk, with a network and subnetworks loosely calibrated to UK experience during the financial crisis, with a focus on both exposure to property markets and extent of maturity mismatch.

This talk is part of the Isaac Newton Institute Seminar Series series.

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