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

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.