Abstract
In this work we investigate whether information theory measures like mutual information and transfer entropy, extracted from a bank network, Granger cause financial stress indexes like LIBOR-OIS (London Interbank Offered Rate-Overnight Index Swap) spread, STLFSI (St. Louis Fed Financial Stress Index) and USD/CHF (USA Dollar/Swiss Franc) exchange rate. The information theory measures are extracted from a Gaussian Graphical Model constructed from daily stock time series of the top 74 listed US banks. The graphical model is calculated with a recently developed algorithm (LoGo) which provides very fast inference model that allows us to update the graphical model each market day. We therefore can generate daily time series of mutual information and transfer entropy for each bank of the network. The Granger causality between the bank related measures and the financial stress indexes is investigated with both standard Granger-causality and Partial Granger-causality conditioned on control measures representative of the general economy conditions.
Highlights
The stability of the financial system is a basic condition for sustainable growth of an economy as a whole
The approach we propose in this paper is multistage: first we fit a graphical model based on the LoGo algorithm to infer the structure of significant interconnections among banks, afterwords we calculate graph based measures, namely Mutual Information and Cross Entropy to be used for further investigations
Given the long time horizon considered in this paper, we would expect to see only some constant properties of the banks emerging from the graphical model structure, like characteristics connected to the bank dimension, business model, nationality
Summary
The stability of the financial system is a basic condition for sustainable growth of an economy as a whole. The crisis was characterized by the bankruptcy or distress of several large banks like Bear Stearns, Citigroup, Lehman Brothers, Merrill Lynch, Wachovia, and Washington Mutual that in several cases, had to be rescued by the government. Such instability of the financial system resulted in a severe credit and liquidity crunch in the financial markets affecting the real economy. This type of risk, wherein the entire financial system is simultaneously distressed, is generally referred to as systemic risk. Systemic risk, when it occurs, impacts financial markets and institutions, and the real economy as a whole due to decreases in capital supply and increases in capital costs
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