Size and complexity in model financial systems

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...

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Bibliographic Details
Published in:Proceedings of the National Academy of Sciences - PNAS 2012-11, Vol.109 (45), p.18338-18343
Main Authors: Arinaminpathy, Nimalan, Kapadia, Sujit, May, Robert M
Format: Article
Language:English
Subjects:
Alternative banking
assets
Bank assets
Bank capital
Bank failures
Bank liquidity
Bank loans
Bank markets
banking
Banking crises
Banks
capital
credit
Diversification
dynamic models
Economic crisis
Economic models
Economic stabilization
Economics
ecosystems
Financial Management
infectious diseases
issues and policy
Loans
Models, Economic
prices
Public policy
risk
Social Sciences
Trust
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Summary: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.
ISSN:0027-8424
1091-6490
DOI:10.1073/pnas.1213767109