Filling in the blanks: network structure and interbank contagion

The network pattern of financial linkages is important in many areas of banking and finance. Yet, bilateral linkages are often unobserved, and maximum entropy serves as the leading method for estimating counterparty exposures. This paper proposes an efficient alternative that combines information-th...

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Bibliographic Details
Published in:Quantitative finance 2015-04, Vol.15 (4), p.625-636
Main Authors: Anand, Kartik, Craig, Ben, von Peter, Goetz
Format: Article
Language:English
Subjects:
Bank examinations
Banking industry
Entropy
Information theory
Interbank markets
Intermediation
Networks
Risk exposure
Social networks
Studies
Systemic risk
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Summary:The network pattern of financial linkages is important in many areas of banking and finance. Yet, bilateral linkages are often unobserved, and maximum entropy serves as the leading method for estimating counterparty exposures. This paper proposes an efficient alternative that combines information-theoretic arguments with economic incentives to produce more realistic interbank networks that preserve important characteristics of the original interbank market. The method loads the most probable links with the largest exposures consistent with the total lending and borrowing of each bank, yielding networks with minimum density. When used in a stress-testing context, the minimum-density solution overestimates contagion, whereas maximum entropy underestimates it. Using the two benchmarks side-by-side defines a useful range that bounds the cost of contagion in the true interbank network when counterparty exposures are unknown.
ISSN:1469-7688
1469-7696
DOI:10.1080/14697688.2014.968195