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Size and complexity in model financial systems.

Authors
  • Arinaminpathy, Nimalan
  • Kapadia, Sujit
  • May, Robert M
Type
Published Article
Journal
Proceedings of the National Academy of Sciences
Publisher
Proceedings of the National Academy of Sciences
Publication Date
Nov 06, 2012
Volume
109
Issue
45
Pages
18338–18343
Identifiers
DOI: 10.1073/pnas.1213767109
PMID: 23091020
Source
Medline
License
Unknown

Abstract

The global financial crisis has precipitated an increasing appreciation of the need for a systemic perspective toward financial stability. For example: What role do large banks play in systemic risk? How should capital adequacy standards recognize this role? How is stability shaped by concentration and diversification in the financial system? We explore these questions using a deliberately simplified, dynamic model of a banking system that combines three different channels for direct transmission of contagion from one bank to another: liquidity hoarding, asset price contagion, and the propagation of defaults via counterparty credit risk. Importantly, we also introduce a mechanism for capturing how swings in "confidence" in the system may contribute to instability. Our results highlight that the importance of relatively large, well-connected banks in system stability scales more than proportionately with their size: the impact of their collapse arises not only from their connectivity, but also from their effect on confidence in the system. Imposing tougher capital requirements on larger banks than smaller ones can thus enhance the resilience of the system. Moreover, these effects are more pronounced in more concentrated systems, and continue to apply, even when allowing for potential diversification benefits that may be realized by larger banks. We discuss some tentative implications for policy, as well as conceptual analogies in ecosystem stability and in the control of infectious diseases.

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