ABSTRACT

Financial institutions are connected to each other via a sophisticated network of multilateral exposures. Through these linkages, distress or failure of a financial institution triggering large unexpected losses on its trades can seriously affect the financial status of its counterparties. It is such negative externalities and the significant spillovers to the real economy that are the essence of systemic risk.

This thesis extends systemic risk literature in two directions. First, it develops a majorization-based tool to compare financial networks in terms of systemic losses with a focus on the implications of liability concentration. Specifically, we quantify liability concentration by applying the majorization order to the liability matrix that captures the interconnectedness of banks in a financial network. We develop notions of balancing and unbalancing networks to bring out the qualitatively different implications of liability concentration on the system's loss profile. An empirical analysis of the network formed by the banking sectors of eight representative European countries suggests that the system is either unbalancing or close to it. This empirical finding, along with the majorization results, supports regulatory policies aiming at limiting the size of gross exposures to individual counterparties.

Second, this thesis proposes a multi-period clearing framework, where the level of systemic risk is mitigated through provision of liquidity assistance. The interbank liability network evolves stochastically over time, and assets of defaulted banks are sold to qualified banks within the network through a first-price sealed-bid auction. We find that policies targeting systemically important banks are more effective in core-periphery network structures, whereas those maximizing the total liquidity in the system are preferred in random network configurations. We assess sensitivity of systemic risk to variations in interbank liabilities as well as to their correlation structure.