Systemic risk management as a network optimization problem

Author: Stefan Thurner

Abstract

Systemic risk arises as a multi-layer network phenomenon. Layers represent either direct financial exposures, including interbank liabilities, derivative- or foreign exchange exposures, or indirect exposures that emerge through common asset holdings of financial institutions — overlapping portfolios. Overlapping portfolios create exposures that are caused by price movements of the underlying financial assets. Based on the knowledge of portfolio holdings of financial players we quantify the systemic risk content of overlapping portfolios. We present an optimization algorithm that minimizes systemic risk by optimally rearranging overlapping portfolio networks, under the constraints that the risk-return characteristics of the individual portfolios are unchanged. We demonstrate the power of the method on the overlapping portfolio network of sovereign exposure between major European banks by using the data from the European Banking Authority stress test of 2016. We show that systemic-risk-efficient allocations are accessible by the optimization, and how the contagion probability is reduced in the optimized network.  Results are confirmed with a simulation of fire sales in the government bond market.