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In financial ecosystems, big banks trample economic habitats and spread fiscal disease
Date:11/14/2012

Kapadia said. "Twice the bank size doesn't mean twice the impact from bank failure. Instead, the financial network acting together with confidence effects can be a strong amplifier, so that you get more than twice the impact."

A banking system akin to that in the United States wherein a few banks control most assets worsened these effects. The researchers created a more concentrated model using datafrom the American financial sector indicating that 1.4 percent of U.S. banks controlled 79 percent of banking system assets in the first quarter of 2011. In their simulation, three banks out of 200 were large, but each was 250-times the size of a smaller bank. In such a model system the failure of a single large bank was even more catastrophic, while the system is virtually unaffected by small banks until they all fail.

Another scenario factored in diversification by allowing big banks to hold twice as many types of assets as small banks. The researchers found that large banks with a variety of holdings can survive hard times longer, but once they eventually suffer failure, the implications for the system can be more widespread than in the other models.

Although diversification is lauded as a stopgap to crisis, Arinaminpathy said, he and his co-authors found that it also could heighten vulnerability by increasing the exposure to risk on numerous fronts.

"Diversification does protect a financial institution somewhat, but once several assets sour, banks now have many avenues for transmitting and contracting contagions," he said. "So looking at things on a systemic level, variety can be a bad thing once a bank fails and the outcome can be just as destructive, if not more."

The researchers plan to build on their work with models that more closely resemble real banking systems, as well as explore indicators of what makes a bank systemically important and how risk builds up in a system over time, Arinaminpathy and Kapadia said.


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Contact: Morgan Kelly
mgnkelly@princeton.edu
609-258-5729
Princeton University
Source:Eurekalert

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