EFFICIENCY AND STABILITY OF A FINANCIAL ARCHITECTURE WITH TOO-INTERCONNECTED-TO-FAIL INSTITUTIONS...
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Transcript of EFFICIENCY AND STABILITY OF A FINANCIAL ARCHITECTURE WITH TOO-INTERCONNECTED-TO-FAIL INSTITUTIONS...
EFFICIENCY AND STABILITY OF A FINANCIAL ARCHITECTURE WITHTOO-INTERCONNECTED-TO-FAIL INSTITUTIONS
MICHAEL GOFMAN, UW-MADISON
August 28, 2014
• Study efficiency-stability trade-off for different financial architectures.
Implication for the desired structure of the financial system
Implications for the costs and benefits of too-interconnected-to-fail banks and whether they are systemically important
Implications for understanding the relationship between contagion and diversification of banks
Comparative statics on a calibrated network by holding the density constant and decreasing heterogeneity across banks in the number of counterparties
Use a model with endogenous exposures between banks to compute market efficiency before and after contagion
Objectives
Trading Model:
Mapping from endowments to equilibrium allocations for any possible network of trading relationships
The Proposed Framework
Financial Architecture
Unobservable:
Network of trades:- Density- Max in-degree- Max out-degree- Diameter- Size
Prices, profits, volume
Efficiency
Unobservable:
Observable:
Financial Architecture
Price-setting mechanism: bargaining, auctions.
Financial Architecture – Network of Trading Relationships
Distribution of endowment and valuations shocks
Stability
Illustration of the Model
1Initial allocation:E(1)=1
V(1)=0.3 V(2)=0
Privatevalue: V(5)=0.6
V(4)=1Feasiblefirst-bestallocation
V(3)=0
2 3 4
5
Valuation: P(5)=0.6
P(1)=0.525 P(2)=0.5625 P(3)=0.75 P(4)=1
Welfare loss = 1-0.6=0.4Surplus loss =welfare loss/first-best surplus = 0.4/(1-0.3)=0.57
,𝐵𝑖=1−0.5
𝑁 (𝑖 ,𝑔)
Model Fit: Visualization
Equilibrium daily network of trades in the model. Only one third of all trading relationships are equilibrium trades.
Network of trades in the Fed funds market on September 29, 2006 Source: Bech and Atalay (2010)
Model Data
Equilibrium Network of Trades: Model vs. Data
* Data Source: “The Topology of the Federal Funds Market” Bech and Atalay , Physica A, 2010
3 parameters to match 5 moments using SMM, 5 std. dev. (not targeted) also match well.
Efficiency Before and After Contagion
• Failure of the most interconnected bank triggers failure of counterparties with exposure above 15%.
• Exposure of bank A to bank B = loans from A to B / all loans by A.
Average Cascade Size from Failure of the Most Interconnected Banks
• Between 30% to 55% of banks fail due to endogenous contagion.
• The number of bank failures is non-monotonic.
Contagion Scenario with Cumulative Losses (Preliminary)
• Cascade is triggered by failure of the most interconnected bank
• A bank fails if exposure to all banks failed in the past is above 15%.
20 40 60 80 100 120 140 1600
200
400
600
800
1000
Maximum Number of Counterparties
Number of failed banks
• Efficiency is as important as stability but it is frequently omitted in policy discussions and is rarely quantified.
• Bridging the gap between theory and empirics is important for financial regulation. To compute efficiency we need to use some trading model, the calculation is more reliable if the model can also match the data.
• Using a trading model to compute endogenous exposures between banks is important for studying contagion risk.
• To understand the costs and benefits if too-interconnected-to-fail banks the comparative statics should be with respect to the variance of the degree distribution, holding the mean of the distribution constant.
Final Remarks
• Cumulative contagion: a bank fails if exposure to all banks failed in the past is above a threshold.
• Add counterparty risk to the trading model.
• In addition to the dynamical allocation in the network of trading relationships, allow for non-iid shocks and study trading when traders anticipate they will receive position/negative shocks in the future. Might improve the fit of the model even further.
• Strategic network formation to narrow down what counterfactual network would form under regulation that puts constrains on banks.
Model Limitations and Future Work