In Systemic Risk: The Dynamics of Modern Financial Systems, Prasanna Gai, professor of macroeconomics at the University of Auckland and former academic fellow at the Reserve Bank of New Zealand, explores new ideas in the study of financial crises, systemic risk, and contagion. In the wake of the global financial crisis, there is a critical need for a substantial reassessment of the fundamental workings of financial systems, their interactions with the real economy, and the circumstances that tip such systems from stability to instability. Gai provides a fresh look at these increasingly important fields.
The author analyzes the financial system as a complex adaptive network and discusses how the literature in such disparate disciplines as engineering, epidemiology (the study of the patterns, causes, and effects of health and disease conditions), and ecology improves our understanding of financial stability. Although his example of financial contagion has many similarities to the epidemiological literature on the spread of disease in networks, it has two key differences. First, in epidemiological models, the susceptibility of a person to contagion from an infected neighbor does not depend on the health of the person’s other neighbors. In contrast, contagion to a financial institution following the default of one of its counterparties is more likely to occur if another of its counterparties has also defaulted. Second, in most epidemiological models, higher connectivity simply creates more channels of contact through which infection can spread, increasing the potential for contagion. Gai contends that higher connectivity also produces counteracting risk-sharing benefits because exposures are diversified across a wider set of institutions.
Gai also draws from other fields, including the microeconomics of banking, quantitative risk management, coordination games, and the theory of networks. He describes financial systems as displaying a robust yet fragile tendency: Though the probability of contagion is likely low, the effects are extremely widespread when problems do occur. These financial systems have risky characteristics that are exacerbated by the fire sale of assets and hoarding of cash by banks. The book discusses the network consequences of the failure of large interconnected financial institutions, explains how important funding markets can freeze up across the entire financial system, and shows how the pursuit of secured finance by banking institutions can generate systemic risks. These insights are then used to model banking systems that illustrate how financial sector regulators are beginning to quantify the stress in financial systems.
Gai’s primary thesis is that an analytical understanding of systemic risk requires an understanding of network effects, fire sale effects, and the funding of liquidity risk. Default by one bank can trigger problems in others, setting off a cascade of defaults. Gai refers to this phenomenon as hysteresis, which arises from network structure. As conditions change, a bank looks to its neighbors before deciding on a course of action. If those neighbors have taken a particular action, the bank’s best response is to follow suit, leading to a readjustment of balance sheets across the network. The more neighbors a bank has, the larger the spillover effect across balance sheets and the more significant the hysteresis.
Troubled institutions may opt to initiate fire sales of assets either as a defensive action or as a prelude to default. Fire sales reduce valuations of common assets for others in the system and exacerbate both the probability and the potential impact of contagion. Financial firms can also withdraw funding from counterparties as an additional defense, further compounding the crisis. A general insight is that these factors combine to generate excess kurtosis in the distribution of aggregate financial system losses. Although the financial system may be robust to most shocks, when these low-probability/high-impact problems do occur, the effects can be devastating.
The book’s substantive themes include financial contagion, the collapse of secured and unsecured funding markets, and the consequences of the dynamic adjustment, for systemic risk, of bank balance sheets. Network models show how financial connectivity can be a double-edged sword, serving to both spread and increase risks to the system. Ideas from the literature on coordination games are combined with network models to illustrate the consequences of banks’ dynamic adjustment of balance sheets in a system context.
Gai concludes by arguing that financial systems, like other complex networks, are characterized by evolutionary innovations produced by a combination of mutation and natural selection. Although regulators will never be able to keep up with the pace of innovation, understanding the trade-offs between robustness and the ability to innovate and mutate will be a crucial task in the future. Policies in response to the present crisis may, through regulatory arbitrage, generate mutations that will compromise future financial stability. However, the short-term stability generated by such policies could sow the seeds of innovations that will make the financial system less risky. Ultimately, in Systemic Risk, Gai successfully argues that a proper assessment of systemic risk and contagion requires an understanding of network dynamics.