ECC3841 Chap.8 Financial Networks and Systemic Risk
Financial Networks and Systemic Risk
Financial networks transmit distress because one banks liability is another banks asset. Portfolio losses reduce equity; default writes down creditor claims and can trigger further insolvency. Liquidity problems differ from solvency problems, though fire sales can connect them. Connectivity diversifies individual exposure while adding contagion routes, so its net effect depends on position size, capital and recovery.
Cascade questions are balance-sheet calculations, not visual guesses.
What this chapter covers
- 01
Maturity mismatch and bank runs
- 02
Liquidity versus solvency
- 03
Outside and interbank assets
- 04
Equity as a loss buffer
- 05
Default recovery and creditor write-downs
- 06
Cascade rounds
- 07
Diversification versus contagion routes
- 08
Guarantees, liquidity support and bailouts
Worked example · free
Find an insolvency threshold
- +1Initial equity is 70 minus 58, equal to 12.
- +1A shock fraction s destroys 50s of value.
- +1Write shocked equity as 12 minus 50s.
- +1Solve 12 minus 50s below zero, giving s above 0.24.
- +1Interpret 24% as the zero-equity boundary.
Key terms
- Insolvency
- A state in which the value of assets is below liabilities and equity is negative.
- Liquidity shortage
- An inability to meet near-term payments despite potentially adequate long-run asset value.
- Interbank claim
- A bank asset created by another banks debt obligation.
- Recovery rate
- The share of a defaulted claim ultimately paid to creditors.
- Fire sale
- Rapid asset selling that depresses prices and creates further balance-sheet losses.
- Systemic risk
- Risk that distress spreads across institutions and impairs the financial system.
- Capital buffer
- Positive equity available to absorb asset losses before insolvency. A larger buffer raises the portfolio shock or counterparty write-down the bank can survive under the stated liability structure.
- Debt direction
- The mapping from borrower obligation to lender claim. If one bank owes another, the same amount appears as a liability for the debtor and an interbank asset for the creditor.
- Default cascade
- A sequence in which an initial failure reduces creditor asset values and creates further failures. Each round must use the stated recovery rule and freshly recomputed bank equity.
- Common asset exposure
- Portfolio overlap that makes several banks lose value from the same external shock. It creates correlated distress even when the institutions have no direct interbank debt link.
- Deposit guarantee
- A promise protecting eligible depositor balances if a bank fails. It can reduce run incentives but does not by itself restore the value of an insolvent banks assets.
- Clearing payment
- The amount a distressed institution can pay creditors after available assets and claim priority are applied. Clearing values determine actual creditor losses rather than assuming every default pays zero.
- Exposure concentration
- The share of interbank assets tied to one or a few counterparties. Concentration raises the loss from an isolated default even when the banks total interbank assets are unchanged.
- Emergency liquidity
- Short-term funding supplied to meet immediate payments when long-run asset value may remain adequate. It addresses timing and cannot by itself repair a bank whose total assets are below liabilities.
- Shock threshold
- The smallest specified portfolio loss that reaches the solvency boundary under current assets and liabilities. The answer must name the shocked asset base and preserve the strict default inequality used by the model.
- Resolution policy
- The rules used to allocate losses and continue or close a failed institution. Resolution differs from liquidity support because it applies after solvency has been breached and creditor claims must be settled.
Financial Networks and Systemic Risk FAQ
How does default spread?
A debtor stops paying all or part of an interbank liability, reducing the creditor banks asset value. If the write-down exceeds the creditors capital buffer, another default follows. Trace assets, liabilities, recovery and equity through complete rounds instead of inferring failure from arrows alone.
Are dense networks safer?
They can diversify exposure across counterparties but also create more contagion routes. Capital, exposure size and recovery determine which force dominates. Trace assets, liabilities, recovery and equity through complete rounds instead of inferring failure from arrows alone.
What is the difference between liquidity and solvency?
Liquidity concerns payment timing; solvency concerns total value. A solvent bank can face a run, while fire-sale losses can turn that shortage into insolvency. Trace assets, liabilities, recovery and equity through complete rounds instead of inferring failure from arrows alone.
What is the correct cascade order?
Compute initial equity, apply the direct shock, mark defaults, apply recovery losses to creditors and repeat until no new institution fails. Trace assets, liabilities, recovery and equity through complete rounds instead of inferring failure from arrows alone.
Exam move
Write debt direction in words before using the matrix. If bank j owes bank i, the obligation is a liability for j and an interbank asset for i. Check one arrow against that sentence before filling the rest of the table. Build a mini balance sheet for every bank with outside assets, interbank assets, deposits, interbank liabilities and residual equity.
Compute initial equity first because it is the buffer that absorbs later losses. Apply a percentage shock only to the asset category named in the question. Keep direct portfolio losses separate from counterparty write-downs. Test the strict insolvency condition used by the model and treat zero equity as the boundary unless instructed otherwise.
Mark all first-round defaults, state the recovery assumption and update affected creditors simultaneously. Repeat rounds until no new bank fails. Do not trace a cascade by following arrows visually; recompute values. If liabilities have different seniority, allocate available assets in the stated priority order before finding recoveries. Compare liquidity and solvency explicitly.
A solvent institution can fail to meet immediate withdrawals because assets mature later, while fire-sale discounts can turn a liquidity shortage into a solvency loss. Create a two-column table of remedies: deposit guarantees address panic, central-bank lending bridges liquidity, recapitalization repairs capital and bailouts prevent bankruptcy costs while changing incentives. Explain moral hazard rather than merely naming it.
Connectivity questions need both margins. Splitting exposure across many counterparties can diversify one default, but more links create additional contagion routes and shared dependence. Vary capital, exposure size and recovery in a small stress test rather than calling dense networks safe or fragile by definition. For revision, solve one single-bank loss threshold, one three-bank cascade and one policy comparison.
Check assets minus liabilities at every step and keep enough precision near thresholds. Then reverse one debt arrow and explain how creditor and debtor positions switch. Add common asset holdings to see how correlated losses differ from direct interbank transmission. Finish every answer by naming the balance-sheet feature that drove fragility and the assumption most likely to change the result.
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