Entropy of Global Financial Linkages

Abstract

This paper proposes network entropy as a tool for measuring diversity of highly connected financial networks. The computation of network entropy hinges on eigenvector centrality and Shannon entropy. Two policy-related findings emerge from this research. First, regarding time variation of network entropy, international diversification of the global financial network constructed from foreign claims of international banks has retreated since the financial crisis of 2007-2008. Foreign claims among 20 reporting countries have become more concentrated on core countries such as US and UK since 2009. The change is more vividly captured by network entropy with an unprecedented drop of the measure. This finding illustrates that network entropy is a more acute measure for diversity of a financial network due to the inclusion of information about financial network structures captured by eigenvector centrality. Second, on the subject of financial linkages, the results reveal sizable regional heterogeneity. In both developing Asia &Pacific area and developing Africa & Middle East area, there is a negative correlation between volatility of changes in foreign claims and international diversification of funding sources measured by funding entropy. In other words, more international diversification is related with lower volatility. Especially in case of developing Europe, however there is no evidence for the relation. This paper also finds interesting regional variations in the relation between international diversification of lending and that of borrowing.