Abstracts

This paper investigates two amplification effects of a financial system in developing individual defaults to a systemic catastrophe. In our model, the financial institutions interconnect via two mutually stimulating channels: their balance sheets are linked directly by holding debt claims against each other; they share the market liquidity to liquidate assets to meet debt liabilities when they face distress. The liabilities network and market liquidity will amplify small and idiosyncratic shocks to a systemic impact, as evidenced by the recent financial crisis. We use optimization with equilibrium constraints to formulate our model of the above financial network to characterize analytically how the topological structures of the system and asset liquidation interact with each other to form the systemic risk. Two multipliers, network multiplier and liquidity multiplier, are identified to capture the above amplification effects. The model has a significant computational advantage and can be solved efficiently. It produces a natural metric for measuring financial institutions' systemic risk exposures. Furthermore, we examine some policy implications yielded from the numerical experiments on the data of European Banking Authority 2013 stress tests.