DOI 10.1007/s10614-014-9443-x
S. Langfield (B)
European Central Bank, Frankfurt, Germany
e-mail: samlangfield@gmail.com
S. Langfield
Bank of England, London, UK
K. Soramki
Financial Network Analytics Ltd., London, UK
e-mail: kimmo@fna.fi
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S. Langfield, K. Soramki
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is commonly cited as a trigger for general financial markets distress in autumn 2008
(Diamond and Rajan 2009), even though counterparty exposures to Lehman ultimately
proved to be relatively well contained (Scott 2012).
In the presence of asymmetric information, banks are typically reluctant to engage
in mitigating transactions, such as those related to insurance against liquidity shocks,
which would be commonplace in normal times when the proportion of lemons is low.
With these behavioural responses, systemic crises can be self-fulfilling. Connectivity
between financial institutions is thus a core component of systemic risk. Due to the
magnitude of the potential cost, systemic risk due to interconnectedness is of interest to
financial regulators, risk managers and, ultimately, society. Studying the phenomenon
of interconnectedness within financial markets is therefore an important and growing
research agenda.
The remainder of this article reviews the literature related to interbank markets from
a systemic risk perspective, focusing on new analytical methods for monitoring interconnectedness in the financial system. Our focus is on research using real trade-level
ot bilateral exposure data that has recently become better available as a consequence of
the financial crisis of 20072008. The next section outlines the advantages of treating
the interbank market as a network of exposures. Section 3 reviews literature investigating the topology of empirical interbank networks. Section 4 reviews the literature
for identifying important banks and Sect. 5 discusses network simulations. Finally,
Sect. 6 concludes with policy implications and directions for future research.
2 The Interbank Market as a Network of Exposures
To study systemic risk, the financial economics literature increasingly treats complex
webs of connections as a network, composed of links and nodes. The network approach
interprets links as a fourth dimension of data: beyond entities, variables and time,
entities are linked to each other at any given point in time by certain variables. The
underlying premise of this network approach is that the structure of links between
entities matters for how those entities respond to shockseven if the precise nature of
this relationship between network structure and resilience is the subject of on-going
research.
Network theory has an established pedigree in the hard sciences, including statistical mechanics, bioinformatics and computing, and other social sciences, such as
anthropology and sociology. Several insights from network theory are common to disparate real-world networks, and have ready applications to financial economics. For
example, highly complex networks tend to exhibit a degree distribution which follows
a power law. In the context of interbank networks, this means that a few large banks
tend to be heavily interconnected, whereas many smaller banks are sparsely connected.
Such structures tend to be robust to random attacks, but fragile to targeted attacks on
systemically important nodes (Anderson and May 1991; Barabsi and Albert 1999).
By inference, most shocks do not result in systemic stress, but targeted shocks to
specific parts of the financial system may be disastrous (Gai and Kapadia 2010). This
insight emphasises the importance of identifying systemically important parts of the
system, including systemically important financial institutions.
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Fig. 1 A pure core-periphery structure (as in Craig and von Peter 2014) with five core banks and 15
periphery banks. Core banks are laid on an inner circle and periphery banks on an outer circle so that they
are closest to the core banks that they interact with. The metrics were calculated and the visualization was
created with FNA (www.fna.fi)
and researchers have since applied their methodology, for example in pursuit of identifying a set of systemically important banks. A core-periphery system is illustrated
in Fig. 1, and has the following properties:
Craig and von Peter (2014) present an algorithm for approximating the core-periphery
structure. The algorithm finds the classification of banks into core or periphery
that minimizes an error score, which is associated with each node is equal to its total
outgoing links that are errors: for nodes classified as periphery this is equal to the
number of links to other nodes classified as periphery, and for nodes classified as core
this is equal to the number of missing links to other nodes classified as core. The
classification error is the sum of the nodes errors.
Real banking systems deviate somewhat from this perfect core-periphery structure,
with some core banks not linked to all other core banks or some links between periphery
banks. Nevertheless, the core-periphery concept has proven useful for understanding
markets and banking systems and for identifying important banks. For example, Craig
and von Peter (2014) found a core-periphery structure in the German banking system
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and also found that bank-level features such as connectedness and balance sheet size
were helpful for predicting a banks classification as core or periphery. The finding
that large, well-connected banks are more likely to be in the core lends support to
the core-periphery structure as a realistic model for banking systems. Craig and von
Peter also find that the core-periphery classification of banks in the Germany system is
stable over time; Fricke and Lux (2013) report similar findings for the e-MID trading
platform, and Langfield et al. (2014) report a core-periphery structure in the UK
interbank system.
In network terminology, the core banks form a complete graph, and the periphery
banks are linked only to core banks. A perfect core-periphery network is shown below,
with blue nodes representing core banks and orange nodes representing periphery.
Links can represent, for example, exposures or payment flows between banks.
Empirical network analysis, as reviewed so far, contributes to the existing theoretical
results on systemic risk in the interbank market by considering the overall structure
of the network (thus going beyond the earlier focus on its degree of completeness).
It also provides a stronger basis for the assessment of contagion risk by means of
counterfactual simulations.
A rich literature examining interbank exposure networks has emerged in recent
years. While each network of interbank exposures is different, some common features
have been uncovered. Interbank exposure networks are often complex, with a small
number of highly connected large nodes that connect to a large number of small nodes
with few links. The cores of the networks, composed of the most connected banks, are
often much more important than nodes in the periphery. When network have a large
number of banks, such structures may resemble scale-free networks with power law
degree distributions (see Fig. 2). Another useful structure found in many network is
a core-periphery structure, in which core nodes connect to each other and periphery
nodes connect to nodes in the core.
4 Identifying Important Banks
In the past decade, significant progress towards understanding the structure and functioning of complex networks has been made within the fields of statistical mechanics
and social network analysis.
A multitude of centrality measures has been developed, each with an explicit or
implicit network process in mind. Borgatti (2005) identifies several stylized processes.
According to his typology, a process can progress in the network through geodesic
paths, paths, trails or walks. Processes that travel via geodesic (shortest) paths are, for
example, problems of the traveling salesman type: i.e. they always take the shortest
route between two nodes. Processes that travel via paths need not necessarily use the
shortest route, but do not visit any node more than once. These can be, for example,
viral infections (a person becomes immune once infected) or the routing of internet
traffic.
Processes that travel along trails do not visit any given link more than once. Such a
process is for example the spread of gossip where a person may forward it to several
other people or hear the same news from several different people, but a person typically
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Fig. 2 A small directed and weighted network of 50 nodes created with a version of the Barabsi and Albert
(1999) model of growth and preferential attachment presented in Soramki and Cook (2013). The node
sizes scale with the degree of the nodes and the link width with their weight. Even with a small network
like this the preferential attachment is clearly visible as a handful of nodes which are much more connected
than the other nodes in the network. The layout is based on the algorithm of Fruchterman and Reingold
(1991). The metrics were calculated and the visualization was created with FNA (www.fna.fi)
does not hear the same news more than once from the same person. Processes that are
characterized as walks are not restricted in their movement.
Further on, Borgatti characterizes processes in the dimensions of parallel duplication, serial duplication and transfers. In parallel duplication the process spreads at the
same time from a node to all its neighbours. In serial duplication it duplicates one
link at a time. An example of the former is an e-mail broadcast and of the latter viral
infection (assuming no one infects multiple people at exactly the same time). Transfer
on the other hand, moves something (e.g. asset ownership) in the network. When it
is moved, it leaves the originating node and is now possessed by the receiving node.
This is the case with payments.
The most commonly used centrality measures are Degree, Closeness and Betweenness proposed by Freeman (1979) and different variations of Eigenvector centrality
which was pioneered by Katz (1953) and Bonacich (1972 and 1987). Degree centrality (or simply Degree) counts the number of neighbours of each node. It is a local
measure that only takes the immediate neighbourhood of the node into account. It can
count neighbours with incoming links, outgoing links or either, and can be weighted
by link properties; for example, the weighted out-degree is referred to as out-strength.
The insight underlying Closeness centrality is that nodes with shorter geodesic paths
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to other nodes are more central. It is generally calculated as the average length of
geodesic paths from a node to each other node in the network. Betweenness centrality
defines as central those nodes through which a high share of geodesic paths pass.
What is known today as Eigenvector centrality encapsulates the idea that the centrality of a node depends directly on the centrality of the nodes that link to it (or that it
links to). Eigenvector centrality measures assume parallel duplication along walks. A
famous commercialization of Eigenvector centrality is Googles PageRank algorithm
(Page et al. 1999), which adds a random jump probability for dangling nodes and
thus allows the measure to be calculated for all types of networks. PageRank and
Eigenvector centrality can be thought of as the proportion of time spent visiting each
node in an infinite random walk through the network.
In financial networks banks (nodes) transfer financial assets related to customer
requests or their own trading along directed links of the network. When a transaction
is made the asset is no longer available to the sender, and the receiver of the asset
can transfer the asset to any other participant in the system. Using the terminology of
Borgatti (2005), the transfer process takes place along walks in the network as any
participant can both transfer assets and receive asset transfers from any participants
multiple times. Traditional measures of centrality that have been developed with other
types of processes in mind (e.g. processes transmitted along geodesic paths or trails
or processes based on duplications instead of transfer) may not be able to accurately
rank nodes with respect to their importance or vulnerability in exposure networks.
The literature on identifying systemically important banks in interbank networks
is, however, very new. Chan-Lau et al. (2009) is an early discussion on using network analysis for tackling the too-connected to fail problem. A thorough survey on
systemic risk analytics by Bisias et al. (2012) leaves the field still virtually empty
mostly due to the unavailability of granular link data needed for this type of analysis.
Recently, Battiston et al. (2012) have proposed a metric DebtRank to quantify
the systemic importance of banks. DebtRank is based on the network structure of an
exposure network, and represents the proportion of the exposure networks total value
that could be affected by distress or default in a given bank. Aldasoro and Angeloni
(2013) develop several metrics that highlight different aspects of systemic importance
based on network balance sheet contagion.
Some aspects of the interbank markets are better modelled as flows, such as interbank payments, the flow of collateral across accounts or the flow of margin calls related
to securities trading. Currently-used metrics for the systemic importance of banks in a
payment system tend to focus on local measures, such as the number or value of payments made or received, and ignore the systems network structure. Network-based
centrality measures can give a more complete description of the importance of banks in
the network. However, existing network-based metrics have been developed with other
applications in mind and do not capture the features of payment systems. Soramki
and Cook (2013) aim to improve this by presenting a new algorithm, SinkRank, for
identifying central nodes in such systems.
SinkRank models the system as an absorbing Markov system in a directed and
weighted network. Links in the network define transition probabilities of the process
being modelled. The measure of interest is the number of steps along the links that
the process, starting from anywhere in the network, takes before reaching a given
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node. The faster the node is reached, the more important it is. The basic version of
SinkRank can easily be extended to calculate the importance of a set (or a portfolio) of
nodes.
In order to simplify the complex network structure and dynamics, the literature
has recently developed metrics that summarize information about aspects important
to policysuch as the relative importance of banks in the network. In adjacent fields
such as sociology or statistical mechanics, where network models have been widely
used, the centrality of nodes has been an active area of research for decades. The
application of these metrics for exposure networks is, however, not straightforward
as the contagion process and spreading trajectories depend on the question at hand.
Models developed for the analysis of interbank networks are based on cascading
processes or Markov chains (DebtRank, SinkRank, PageRank) are likely better than
models based on geodesic paths (Closeness, Betweenness) for identifying important
banks in exposure networks. The development of accurate metrics for identifying
important bankswhich may change on a daily basis as a result of on-going trading
activityis of great interest for regulators. First, it allows them to direct monitoring
resources to banks that are of more importance in a given market, and second it provides
them valuable information on likely contagion effects in the case of a disruption at
that bank.
5 Simulating Interbank Exposure Networks
Counterfactual simulations models often have roots in various percolation and cascade
models developed within statistical mechanics and network theory. One branch of this
literature has investigated the resilience of processes in different network topologies
in terms of a connectivity (or percolation) threshold (examples are shown by Bollobs
(1998), Moore and Newman (2000) and Callaway et al. (2000)), at which a network
dissolves into several disconnected components. A well-known finding is that scalefree networks are more robust to random failures than other types of networks, although
they are fragile with respect to the removal of the very few highly connected nodes.
However, such static failure models are more applicable to networks where the interest
is the availability of paths between nodes in the network (e.g. in transportation)but
are less applicable to networks of monetary flows which contain both flows via the
shortest paths as well as any walks within the network.1 Another branch of the literature
has studied the impact of perturbations that cascade through the network on the basis
of established theoretical or domain-specific rules (Sachtjen et al. (2000) and Kinney
et al. (2005) for power networks). In these dynamic models, nodes generally have a
capacity to operate at a certain load and, once the threshold is exceeded, some or all of
the nodes load is distributed to neighbouring nodes in the network. While the detailed
dynamics depend on the rules applied for the cascades, generally the most connected
nodes (or nodes with highest load in relation to overall capacity) are more likely than
an average node to trigger cascades.
1 A walk is a traversal of nodes along links without any constraints. In contrast a trail is a walk where a
given link is not visited twice and a path is a walk where a given node is not visited twice.
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Cascade models have been applied to various systems in fields such as geology,
biology and sociology, as shown by Jensen (1998). This research has demonstrated
that models made of very simple agents, interacting with neighbouring agents, can
yield surprising insights about system-level behaviour. Models applied to financial
systems have been developed by, for example, Cifuentes et al. (2005) and Nier et al.
(2007), who also used simulated exposure data, and Bastos e Santos and Cont (2010)
who use data from the Brazilian credit registry. More recently, Lorenz et al. (2009),
Alves et al. (2013) and Georg (2013) have applied cascade models to systemic risk
analysis.
The literature developing agent-based models for understanding financial systems
goes back to the Santa Fe Artificial Stock Market in the early 1990s (Arthur et al.
1997). Modelling financial markets and prices has remained an active field. As for
models on financial stability, Martinez-Jaramillo (2007) and Martinez-Jaramillo and
Tsang (2009) study extensively evolution in agent-based financial markets. Markose
et al. (2012) develop agent based model for contagion from credit default swaps.
An area of simulations are models intended to describe networks that follow characteristics frequently documented for financial networks such as disassortative behaviour, power laws in the degree distributions and power laws in the distribution of
bank sizes. Soramki and Cook (2013) develop an algorithm that produces networks
similar to found for the Fedwire interbank payment system in Soramki et al. (2007)
and Montagna and Lux (2013) develop a method based on a fitness algorithm and a
representation of the balance sheets of the banks.
Counterfactual simulations are a natural way to model the complex dynamics and
regulators have used them often in the context of introducing new financial infrastructures, or analysing the effects of changes to existing ones. They were for example an
integral part in the regulatory approval of the Continuous Linked Settlement (CLS) system,2 which launched in 2003. Due to systemic importance, regulators placed special
emphasis on assessing its impact on liquidity markets. For this purpose CLS carried
out and overseers evaluated a wide range of simulation scenarios (ECB 2003). Other
examples include the Bank of Japan, who used simulations to evaluate alternative
liquidity saving mechanisms before implementing them (Imakubo and McAndrews
2006). The Eurosystem has recently embraced payment system simulations as an
ongoing oversight tool by specifying how transaction-level data may be used (ECB
2010) and has developed a TARGET2 simulation platform. More recently, Denbee
and McLafferty (2013) used real payment data to quantify the liquidity efficiency that
could be obtained in CHAPS, the UKs large-value payment system, by the implementation of a liquidity saving mechanism.
6 Conclusions and Policy Implications
A rich literature examining interbank exposure networks has emerged in recent years.
The literature divides into three areas: descriptions of interbank exposure networks;
2 CLS is the worlds largest settlement system, settling on peak days in 2013 almost $9 trillion worth of
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simulation and modelling; and the development of new network metrics to describe
network topology and individual banks relative importance.
While each network of interbank exposures is different, common features have been
uncovered. Interbank exposure networks are often complex, with a small number of
highly connected large nodes that have connections with a large number of small nodes
with few links. The cores of the networks, composed of the most connected banks, are
often much more important than nodes in the periphery.
Simulation and modelling is a process that takes into account network structure
and often behavioural rules for the nodes. These rules can be very simple or take into
account the dynamics of their environment. Models with relatively simple rules can be
solved analytically, but models where the rules and their outcomes depend dynamically
on the state of the system usually need some form of agent-based modelling.
In order to simplify the complex network structure and dynamics into something
tractable, the literature has recently developed metrics of interest. In other fields where
network models have been used the centrality of nodes has been an active area
of research for decades. The new metrics particularly suited for interbank networks
identify systemically important banks or sets of banks, and classify banks into core
and periphery.
Further research along these three dimensions is essential for two reasons. First,
despite significant advances, common understanding of the sources of systemic risk
within financial networks remains relatively primitive. Second, policy-makers need
more evidence against which to calibrate macro- and micro-prudential policy tools,
many of which are already available.
Compared with many real-world complex networks, such as those studied in the
hard sciences, financial networks are weakly evolved, and are therefore particularly
prone to instability (Haldane and May 2011). This creates space for policy intervention. Since the 2007-08 financial crisis, the architecture of financial regulation has
been upgraded. In the realm of interconnectedness, two policy innovations agreed by
the G20 are particularly noteworthy. First, the G20 agreed that systemically important banks should be subject to additional capital requirements. Higher levels of loss
absorbency for important nodes should reduce the risk that contagion propagates
through the network of interbank exposures. Second, the G20 agreed that all standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties. Central
clearing of derivative contracts should reduce the quantity of counterparty risk, information asymmetry and complexity in the financial system.
These policy innovations also give rise to research challenges in the field of financial
networks. First, The Basel Committees methodology (2013) to identify systemically
important banks does not incorporate any information on bilateral exposures. As such,
the structure of links between entities is therefore overlooked. Incorporating networkbased measures of systemic importance into the Basel Committees methodology
is an important medium-term goal. Second, mandatory clearing of over-the-counter
derivatives potentially increases the systemic importance of central counterparties.
Investigating this possible unintended consequence should be a priority for research
on financial networks.
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