Optimizing systemic risk through credit network reconstruction

Abstract

Capital buffers can improve the stability of the banking system, but they come at a cost. This study explores the efficient macro-prudential regulation of systemic risk from the perspective of capital network reconstruction. A model of option pricing is proposed to determine the market value of sector credits. Consequently, systemic risk is measured by both credit and interbank contagion risks. Credit network reconstruction is then optimized to minimize systemic risks. Our analysis was based on data from China's banking systems between 2008 and 2020. In different stress tests, the credit network reconstruction generally optimizes systemic risk to the lowest level. At the same time, it may save about 20% to 140% of the cost of capital. The optimization mechanism analysis shows that large banks with stability advantages share more shocks than small banks by reconstructing their sector credit network. As a result, the contagion process of systemic risk is prevented, and bankruptcy cascades are eliminated. These results imply that credit network reconstruction holds great potential for preventing systemic risks.