Systemic Risk: Networks and Bubbles

July 01, 2015

By Eric Fisher 

Nirvikar Singh, a Professor of Economics and Director of the Center for Analytical Finance introduces the panelists
Distinguished Professor, Daniel Friedman

The CAFIN Workshop “Systemic Risk: Networks and Bubbles” brought together academics and policymakers from across the country to University of California, Santa Cruz on the afternoon of May 29, 2015. 

The first workshop panel included three academic presentations (Michael Gofman (University of Wisconsin, School of Business), Matheus Grasselli (University of Toronto, Fields Institute), Camelia Minoiu (IMF, Research Department) and the second workshop panel included policy practitioners Marco Espinosa-Vega (IMF, Institute) and Bradley Jones (IMF, Monetary and Capital Markets Department).  The keynote speech was delivered by Distinguished Professor, Daniel Friedman (UC Santa Cruz, Economics).

The academic presentations highlighted theoretical and empirical research on systemic risk, networks and bubbles.  Michael Goffman presented a model of bank networks in which there was a tradeoff between efficiency and stability.  He showed that the more interconnected networks could improve efficiency but that were more likely to experience contagion from another bank.  The implication of his model was that regulation should consider the tradeoffs that exist between efficiency and financial stability. 

Matheus Grasseli presented a stock flow model of bubbles with households, firms, and banks form a three-dimensional dynamical system for wages, employment, and firm debt.  He showed how speculators entered the model and lead to an unstable equilibrium in which Ponzi financing becomes unsustainable and leads to a crash. 

Camelia Minoiu presented her research on the role of international interbank exposures in the transmission of systemic banking crises across borders.  Using data from Dealogic and Bankscope on syndicated loans from 1990 to 2012, she examined 1,875 banks and estimated the impact of bank exposures on bank performance.

The practitioner presentations stressed the practical applications of theoretical modeling and empirical analysis related to systemic risk and bubbles.  Marco Espinosa-Vega presented network analysis and ways to measure the contribution that each financial institution contributes to systemic risk.  He used data from the Bank of International Settlements to be able to calculate the effect of a failure of an institution on the international banking system.  Using an excel program he showed how the failure of one country’s banking systemic would affect the various other banking systems and how a failure could trigger a cascade of capital losses and failures.  Ultimately, he suggested that capital surcharges on banks could internalize the risk each bank contributes to the system. 

Bradley Jones presented his research and policy work to be able to identify bubbles.  He began by discussing the various theoretical models of bubbles (neoclassical model, limits to learning, frictional limits to arbitrage, institutional limits to arbitrage, irrational behavioral model).  Bradley then used financial data to show how changes in risk premia and various other indicators can provide insights into bubble episodes but that ultimately it is extremely challenging in real time.  He explained that bubbles are most likely driven by the principal incentive structures and rational herding among institutional money managers. 

The workshop ended with a dinner for all participants at the University Center.  CAFIN Director Nirvikar Singh introduced Dean of Arts and Sciences Sheldon Kamieniecki.  Dean Kamieniecki then talked about the founding of CAFIN and the financial support for the workshops, including from alumnus Stephen Bruce.  Stephen Bruce discussed what he learned from the workshop before introducing the keynote speaker Daniel Friedman.  Daniel Friedman gave a presentation about systemic risk in an evolving financial network that drew on his own research and book Morals and Markets.  He began with a history of financial markets, summarized a theories of bubbles and crashes, and explained how we can might want to think about systemic risk and the policies that can be used to address these issues.