DebtRank: A Microscopic Foundation for Shock Propagation

Marco Bardoscia, Stefano Battiston, Fabio Caccioli, Guido Caldarelli

PLoS ONE · 2015 · 150 citations · 40 references

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TL;DR

DebtRank is increasingly used to estimate shock impacts in financial networks, overcoming limitations of traditional default‑cascade models. The study formulates a microscopic theory of financial network instability by iterating balance‑sheet identities and assuming a simple shock‑transfer rule from borrowers to lenders. The framework is applied to data on the top listed European banks from 2008–2013, iterating balance‑sheet identities and using the borrower‑to‑lender shock‑transfer rule. The generalized DebtRank model shows that depending on interbank leverage structure, dynamics can be stable or unstable—unstable cases trigger at least one default, while stable cases yield analytically computable asymptotic states—and that network effects can amplify a 0.5 % external‑asset shock by factors of three in normal periods and six during crises.

Abstract

The DebtRank algorithm has been increasingly investigated as a method to estimate the impact of shocks in financial networks, as it overcomes the limitations of the traditional default-cascade approaches. Here we formulate a dynamical “microscopic” theory of instability for financial networks by iterating balance sheet identities of individual banks and by assuming a simple rule for the transfer of shocks from borrowers to lenders. By doing so, we generalise the DebtRank formulation, both providing an interpretation of the effective dynamics in terms of basic accounting principles and preventing the underestimation of losses on certain network topologies. Depending on the structure of the interbank leverage matrix the dynamics is either stable, in which case the asymptotic state can be computed analytically, or unstable, meaning that at least one bank will default. We apply this framework to a dataset of the top listed European banks in the period 2008–2013. We find that network effects can generate an amplification of exogenous shocks of a factor ranging between three (in normal periods) and six (during the crisis) when we stress the system with a 0.5% shock on external (i.e. non-interbank) assets for all banks.

References

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