Reducing the risk of financial crisis

Today, financial institutions around the world are becoming increasingly inter-dependent. As a result, the actions and interactions of individual organizations, even if small, can catalyze significant cascading effects, leaving the whole system susceptible to profound systemic risk.

As part of the cross-cutting IIASA project Systemic Risk and Network Dynamics, which also involves the institute’s Evolution and Ecology and Risk and Resilience programs, researchers from the Advanced Systems Analysis Program have developed new approaches to modeling network dynamics and to assessing and managing systemic risk using agent-based modeling and game theory.

In recent work, IIASA researchers proposed a potential method—a “systemic risk tax”—to encourage the financial network to self-organize to reduce risk. This tax on individual transactions between financial institutions would be based on the level of systemic risk that each transaction adds to the system—and could essentially eliminate the risk of collapse of the financial system [1].

A further study on this topic used an equilibrium concept inspired by the matching markets literature, and showed that in addition to allowing a regulator to effectively “rewire” the interbank network so as to make it more resilient, a systemic risk tax also does so without sacrificing transaction volume [2].

An alternative way to mitigate systemic risk is to use credit default swaps. These are agreements where the seller will compensate the buyer in the event of a loan default by the third party debtor. Since these transfer the default risk from one bank to another, a market for credit default swaps can be designed to rewire the network of interbank exposures in a way that makes it more resilient to insolvency cascades. This works in a similar way to the systemic risk tax [1], by effectively taxing the credit default swaps based on the level of systemic risk that they add to the system. This makes the entire network more resilient to domino effects [3].

Reducing financial systemic risk is also the aim of the third Basel Accord—a global, voluntary regulatory framework on bank capital adequacy, stress testing, and market risk. However, the accord as planned will not reduce systemic risk in a substantial way, IIASA research, using an agent-based model, has found [4].