Abstract
I show that the solution of a standard clearing model commonly used in contagion analyses for financial systems can be expressed as a specific form of a generalized Katz centrality measure under conditions that correspond to a system-wide shock. This result provides a formal explanation for earlier empirical results which showed that Katz-type centrality measures are closely related to contagiousness. It also allows assessing the assumptions that one is making when using such centrality measures as systemic risk indicators. I conclude that these assumptions should be considered too strong and that, from a theoretical perspective, clearing models should be given preference over centrality measures in systemic risk analyses.
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Notes
- 1.
Note that by setting \(D_{NN}=1\) for the sink node, I am assuming that this node makes payments even though it has no liabilities. This has no implication for the solutions for the other banks, as these payments do not arrive anywhere. Given that the sink node does not need to make payments within the system (and can generally not be interpreted as an entity with a balance sheet), its value for the clearing payment vector can safely be ignored. Other authors (see e.g. [17]) choose to exclude the sink node entirely, in this application, however, it is needed for calculation purposes, in the manner introduced here, as we shall see later.
- 2.
The conditions define that certain subsets of the financial system need to have a positive value of external assets. I will use \(a_i>0 \forall i\) as a sufficient condition.
- 3.
Note that the inclusion of a sink node is crucial here, as [8] show that for \(a_i>0 \forall i\) not all nodes can be in fundamental default. In this setup, it is the sink node that has positive equity value, but is still considered to be in default under any D(x) by construction.
- 4.
In order to find suitable values for s, the model has to be solved first. Given that the aim is to have a small shock size, a reasonable approach would be to start by setting \(s_i = (-o_i + l_i - (Cl)_i)) - \frac{k}{MaxSteps} (l_i - (Cl)_i)\) for a suitable \(MaxSteps = 1000\), e.g., and iterating over \(k = 1, 2, \dots \) until \(D(p) = I\).
- 5.
Another shortcoming of the \(\sigma \)-measure is that differences in initial capitalization, which are a significant driver of contagion dynamics, are canceled out through the shock. If one wanted to use the \(\sigma \) measure for systemic risk analysis, one should consider including another factor like \(\frac{s_i}{o_i + (Cl)_i}\) to capture the initial financial health of firm i.
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Siebenbrunner, C. (2019). Clearing Algorithms and Network Centrality. In: Aiello, L., Cherifi, C., Cherifi, H., Lambiotte, R., Lió, P., Rocha, L. (eds) Complex Networks and Their Applications VII. COMPLEX NETWORKS 2018. Studies in Computational Intelligence, vol 813. Springer, Cham. https://doi.org/10.1007/978-3-030-05414-4_40
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