Financial regulators and policy makers should focus on financial institutions that are ‘too central to fail’ as well as those that are ‘too big to fail’, research published in Scientific Reports this week suggests. The quantitative analysis of emergency loans made by the US Federal Reserve Bank during the financial crisis highlights the importance of an institution’s position within a financial network.
Systemic risk - the risk of default of a large portion of a financial system - depends on the network of financial exposures among institutions, but there is no widely accepted method for working out which institutions in a network are the most important to the stability of the system. Inspired by feedback-centrality measures in networks, such as PageRank, Stefano Battiston and colleagues introduce a new measure of systemic impact, which they call DebtRank. They use DebtRank to analyze a recently released data set with information on the institutions that received aid from the US Federal Reserve Bank through its US$1.2 trillion emergency loans programme from 2008 to 2010.
The authors find that during the peak of the crisis, a group of 22 financial institutions, which received most of the loans, became more central to the network, which means that the default of each one would have a larger economic impact on the whole network. Even small, dispersed shocks to individual banks could thus have triggered the default of a large portion of the system. The authors note that because the network of impact used in the study is a proxy of the real, unknown network, the findings should be regarded with caution, but the study shows the kinds of insights that can be gained using DebtRank.