Systemic Risk: Clustering and Contagion Mechanisms

A free white paper by The Institute for Financial Markets

This academic study proposes a general framework to capture both contagion and clustering mechanisms arising in financial networks when balance sheet linkages across entities exist. Building on Eisenberg and Noe (2001), we develop a multiperiod clearing payment system, where the financial network evolves stochastically over time. We model explicitly the impact of default events on the state of the network and introduce a novel mathematical structure, the systemic graph, to measure the contagion and systemic effects propagating in the network over time. Numerically, we show that domino effects appear when the interbank liability structure is homogeneous, whereas clustering effects are noticeable when the structure is heterogeneous. Larger correlations between interbank liabilities reduce the domino contribution to systemic risk and increase default clustering, especially if liability exposures are highly volatile.

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