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Assessing systemic risk due to fire sales spillover through maximum entropy network reconstruction

Author

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  • Di Gangi, Domenico
  • Lillo, Fabrizio
  • Pirino, Davide

Abstract

Monitoring and assessing systemic risk in financial markets is of great importance but it often requires data that are unavailable or available at a very low frequency. For this reason, systemic risk assessment with partial information is potentially very useful for regulators and other stakeholders. In this paper we consider systemic risk due to fire sales spillovers and portfolio rebalancing by using the risk metrics defined by Greenwood et al. (2015). By using a method based on the constrained minimization of the Cross Entropy, we show that it is possible to assess aggregated and single bank’s systemicness and vulnerability, using only the information on the size of each bank and the capitalization of each investment asset. We also compare our approach with an alternative widespread application of the Maximum Entropy principle allowing to derive graph probability distributions and generating scenarios and we use it to propose a statistical test for a change in banks’ vulnerability to systemic events.

Suggested Citation

  • Di Gangi, Domenico & Lillo, Fabrizio & Pirino, Davide, 2018. "Assessing systemic risk due to fire sales spillover through maximum entropy network reconstruction," Journal of Economic Dynamics and Control, Elsevier, vol. 94(C), pages 117-141.
    • Handle: RePEc:eee:dyncon:v:94:y:2018:i:c:p:117-141
    DOI: 10.1016/j.jedc.2018.07.001
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    More about this item

    Keywords

    Systemic risk; Maximum entropy; Fire sales; Financial networks; Liquidity;
    All these keywords.

    JEL classification:

    • C45 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Neural Networks and Related Topics
    • C80 - Mathematical and Quantitative Methods - - Data Collection and Data Estimation Methodology; Computer Programs - - - General
    • G01 - Financial Economics - - General - - - Financial Crises
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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