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Systemic risk and the dynamics of temporary financial networks

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  • Gong, Rui
  • Page, Frank

Abstract

This paper has two main objectives: first, to provide a formal definition of endogenous systemic risk that is firmly grounded in equilibrium dynamics of temporary financial networks (i.e., short-term lending and investment networks); and second, to construct a discounted stochastic game (DSG) model of the emergence of equilibrium network dynamics that fully takes into account the feedback between network structure, strategic behavior, and risk. Based on our definition of systemic risk we also propose a formal definition of tipping points. Using these tools we provide a strategic approach to making global assessments of systemic risk in temporary financial networks. Our approach is based on three key facts: (1) the equilibrium dynamics which emerge from the game of network formation generate finitely many disjoint basins of attraction as well as finitely many ergodic measures (implying that, starting from any temporary financial network, in finite time with probability one, the dynamic sequence of networks arrives at one of these basins, and once there, stays there), (2) each basin of attraction is homogenous with respect to its default characteristics (meaning that if a basin contains networks having a particular set of defaulted players, then all networks contained in this basin have the same set of defaulted players), and (3) the unique profile of basins generated by the equilibrium dynamics carries with it a unique set of tipping points (special networks) - and these tipping points provide an early warning of network failure.

Suggested Citation

  • Gong, Rui & Page, Frank, 2016. "Systemic risk and the dynamics of temporary financial networks," LSE Research Online Documents on Economics 67810, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:67810
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    File URL: http://eprints.lse.ac.uk/67810/
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    References listed on IDEAS

    as
    1. Gong, Rui & Page, Frank & Wooders, Myrna, 2015. "Endogenous correlated network dynamics," LSE Research Online Documents on Economics 65098, London School of Economics and Political Science, LSE Library.
    2. Paul Glasserman & Peyton Young, 2015. "Contagion in Financial Networks," Economics Series Working Papers 764, University of Oxford, Department of Economics.
    3. Gong, Rui & Page, Frank, 2016. "Shadow banks and systemic risks," LSE Research Online Documents on Economics 105809, London School of Economics and Political Science, LSE Library.
    4. Gong, Rui & Page, Frank, 2016. "Shadow banks and systemic risks," LSE Research Online Documents on Economics 66044, London School of Economics and Political Science, LSE Library.
    5. Zigrand, Jean-Pierre, 2014. "Systems and systemic risk in finance and economics," LSE Research Online Documents on Economics 61220, London School of Economics and Political Science, LSE Library.
    6. Larry Eisenberg & Thomas H. Noe, 2001. "Systemic Risk in Financial Systems," Management Science, INFORMS, vol. 47(2), pages 236-249, February.
    7. Tweedie, R. L., 2001. "Drift conditions and invariant measures for Markov chains," Stochastic Processes and their Applications, Elsevier, vol. 92(2), pages 345-354, April.
    8. Costa, O.L.V. & Dufour, F., 2005. "On the ergodic decomposition for a class of Markov chains," Stochastic Processes and their Applications, Elsevier, vol. 115(3), pages 401-415, March.
    9. A. S. Nowak & T. E. S. Raghavan, 1992. "Existence of Stationary Correlated Equilibria with Symmetric Information for Discounted Stochastic Games," Mathematics of Operations Research, INFORMS, vol. 17(3), pages 519-526, August.
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    More about this item

    Keywords

    systemic risk; counter-party risk; financial networks; supernetworks; tippingpoints; default cascades; basins of attraction; Pareto optimal stationary Markovequilibrium; first passage probabilities; hitting times; hitting time probabilities.;
    All these keywords.

    JEL classification:

    • C7 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory

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