Abstract
We analyze the possibility of reduction of systemic risk in financial markets through Pigouvian taxation of financial institutions, which is used to support the rescue fund. We introduce the concept of the cascade risk with a clear operational definition as a subclass and a network related measure of the systemic risk. Using financial networks constructed from real Italian money market data and using realistic parameters, we show that the cascade risk can be substantially reduced by a small rate of taxation and by means of a simple strategy of the money transfer from the rescue fund to interbanking market subjects. Furthermore, we show that while negative effects on the return on investment (ROI) are direct and certain, an overall positive effect on risk adjusted return on investments (ROI RA) is visible. Please note that the taxation is introduced as a monetary/regulatory, not as a _scal measure, as the term could suggest. The rescue fund is implemented in a form of a common reserve fund.
Highlights
Since the onset of the global financial and economic crisis there has been a lot of suggestions on how to prevent similar future turmoils, how to minimize the contagion likelihood and how to manage the trade-off between stability and ineficiency of the financial system [1,2,3,4,5,6]
We show that the rescue fund in our setting: 1. reduces systemic risk for realistic levels of reserve requirement; 2. increases the risk adjusted return on investment (ROI) for individual financial institutions and for the financial market in general; 3. in certain scenarios can assure the same level of stability for significantly reduced rates of reserve requirements; 4. produce qualitatively the same results in all the cases of the networks we report here
Using the methodology reported in previous sections of this paper we run a number of simulations to investigate the relationships between systemic risk, risk-adjusted ROI, and the rescue fund
Summary
Since the onset of the global financial and economic crisis there has been a lot of suggestions on how to prevent similar future turmoils, how to minimize the contagion likelihood and how to manage the trade-off between stability and ineficiency of the financial system [1,2,3,4,5,6]. One of the most severe issues that regulators and think-tanks encountered to assess the systemic risk was a lack of reliable data [7]. Microeconomic data with lending patterns are scarce and the analyses of the money market (MM) stability with respect to interconnectedness of the system suffers with the issue to be adequately tested with real observations. The systemic risk as a consequence of interconnectivity of market subjects was marked as a clear cause for the wide spread of the crisis [5, 6, 8]. At the peak of the crisis, while central banks and regulatory bodies struggled to come up with short and long term refinancing facilities and/or quantitative easing solutions, it was clear that there are no metrics or models on how to manage negative implications of interconnectivity of market players.
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