Network Centrality, Failure Prediction and Systemic Risk

Abstract

A financial market can be expressed in a network structure where the stocks resides as nodes and the links account for returns correlation. Centrality measure in the financial network structure captures firms’ embeddedness and connectivity in the capital market structure. This paper investigates firms’ centrality in the financial network as an explanatory variable in corporate failure prediction and also as a systemic risk measure. First, when analyzing the CDS spreads, I find peripheral firms in the network to have higher average CDS spreads and higher propensity to CDS jump events. Second, centrality is found to increase the explanatory power of default prediction models and moreover, it is negatively related to failure and bankruptcy probability. This implies that peripheral firms in the network are more likely to fail. Finally, examining the out-of-sample performance of centrality as a systemic risk measure, I find that centrality distinguish correctly the firms that suffered a higher loss during the 2007/2008 crisis period.