Systemic risk and financial networks

Abstract

We develop a network-based probabilistic model to analyze systemic risk within a network of interconnected institutions. Harnessing the power of economic connections, we construct a weighted network that effectively captures the extent of direct risk spillovers. Then the risk contagion probabilistic model is constructed with the aid of the risk orbit contagion idea and inter-institutional dependencies. Our model examines contagion characteristics, uncertainty, and interdependence, revealing that neither a ring nor a complete financial network is optimal. We discover that the expected loss of the network does not have a monotonic relationship with the number of partners, depending on the trade-off between the network density and direct risk spillovers to mitigate systemic risk.