Modeling Investment Behavior and Risk Propagation in Financial Networks

Abstract

Connections among institutions in the global financial network create the potential for risk to propagate and for failures to cascade as successive institutions fail. As conditions, such as capital requirements change, institutions may modify their behavior in ways that can fundamentally change the relationships among institutions and lead to substantially different failure dynamics. Increasing capital requirements can, for example, paradoxically increase the potential for failures to propagate by altering the intensity of relationships and risk exposures. Predicting such outcomes and directing policies to reduce overall systemic risk requires modeling of institutional responses to environmental conditions. This paper discusses an approach based on inverse optimization of relationship decisions subject to capital constraints. A model of cascading failures and data from national debt cross-holdings illustrate the approach and demonstrate how changing capital requirements may lead to distinct differences in the sequences and extent of failures.