An unified framework for modeling credit cycles and systemic risk assessment

According to Hyman Minsky’s financial instability hypothesis, financial crises arise from systemic risks inherent in economies rather than from random events. Although Minsky’s theory has been mathematically formalized multiple times, existing models often struggle to account for the endogenous nature of risk, especially during transitions between different economic regimes. To address their deficiencies, we present a modeling framework consisting of a single system of equations able to capture the phases of stable growth, bubbles, and crises, as well as the transitions between them. Our research builds on the work of Solomon and Golo, who constructed a family of power law models describing the dynamics of the interest rate formation process, with each model valid in a different financial state. In line with Minsky’s hypothesis, the phase transitions within our model stem from interactions within the financial system endogenously to the model itself, rather than from unexplained external shocks. Moreover, the constructed risk measures help to identify the system threats and assess potential collapse magnitudes. Our approach may be important in financial security research, as it offers a comprehensive mathematical, interpretable rationale for regime shifts, particularly during financial crises.