A hybrid approach to assess systemic risk in financial networks

Daniele Petrone1 and Vito Latora1

arXiv:1610.00795v1 [q-fin.CP] 3 Oct 2016

School of Mathematical Sciences, Queen Mary University of London. Mile End Road, London E1 4NS, UK
(Dated: October 5, 2016)
We propose a credit risk approach in which financial institutions, modelled as a portfolio of risky
assets characterized by a probability of default and a correlation matrix, are the nodes of a network
whose links are credit exposures that would be partially lost in case of neighbours default. The
systemic risk of the network is described in terms of the loss distribution over time obtained with a
multi-period Montecarlo simulation process, during which the nodes can default, triggering a change
in the probability of default in their neighbourhood as a contagion mechanism. In particular, we
have considered the expected loss and introduced new measures of network stress called PDImpact
and PDRank. They are expressed in monetary terms as the already known DebtRank and can
be used to assess the importance of a node in the network. The model exhibits two regimes of
weak and strong contagion, the latter characterized by the depletion of the loss distribution at
intermediate losses in favour of fatter tails. Also, in systems with strong contagion, low average
correlation between nodes corresponds to larger losses. This seems at odds with the diversification
benefit obtained in standard credit risk models. Results suggest that the credit exposure network
of the European global systemically important banks is in a weak contagion regime, but strong
contagion could be approached in periods characterized by extreme volatility or in cases where the
financial institutions are not adequately capitalized.
PACS numbers: 87.15.A-, 05.40.-a

I.

INTRODUCTION

One of the lessons that has been learned from the recent credit crisis is that the stability of the financial system cannot be pursued focussing exclusively on each individual bank or financial institution. A broader approach
- macroprudential policy- is required, as interconnections
and interactions are at least as important in contributing to the overall dynamics [16][20][10][14][13]. In order
to limit systemic risk, defined as the risk that a considerable part of the financial system is disrupted, a number of
dedicated boards and committees have been created: the
Financial Policy Committee (FPC) at the Bank of England, the European Systemic Risk Board (ERSB) and
the Financial Stability Oversight Council in the United
States. The regulators are looking at new methodologies
and ideas from different disciplines as it is felt that the
existing models have shown serious limitations, being incapable of predicting the timing and the extent of the
financial crisis [21]. In particular techniques borrowed
from network science [28] [6] have been successfully applied to the study of network resilience to external shocks
[7] [29] and have proven useful in the analysis of financial
systemic risk [17] [12] [22] [5] [27].
In this context, financial institutions are described as
nodes in a network, connected by different kinds of edges,
indicating: cross ownership [31], investments in the same
set of assets (overlapping portfolios) [32] or credit exposures [8] [26]. Another natural way to approach the problem is to consider the financial institutions as a portfolio

Electronic

address: [email protected]

of risky assets with assigned probability of default and

correlations. In this context the risk is thought as the
premium to insure the portfolio against the loss of a percentage of the total asset amount [18]. The framework
we propose in this article aims at combining the two approaches, using all the available information about the
system. The original models used to study network stability [11] relied on a variant of the domino effect to
propagate the stress and, if the original shocks was not
big enough to start the chain reaction, no quantifiable
effect could be calculated. To overcome this limitation
Battistoni et al [4] introduced DebtRank, a new measure
of systemic risk. The DebtRank of node i, is a number measuring the fraction of the total economic value in
the network that is potentially affected by the distress or
the default of node i. The measure presented interesting characteristics such as being expressed in monetary
terms and being able to feel the stress in the network
also in absence of actual defaults. However, it is not
evident how, in the real world, the propagation of the
stress postulated by the model would happen and how
it would translate in an actual loss for the banks. In order to fill this gap Bardoscia et al [2] proposed a slightly
modified model and a derivation of the dynamics for the
shock propagation using basic accounting principles. To
obtain their results, the authors had to make the not
fully financially justified assumption that the exposures
towards other banks lose their value proportionally to the
loss in equity suffered by the borrowing banks, namely:
aij (t + 1) = aij (t)

Ej (t)
Ej (t 1)

(1)

where Ej (t) and aij (t) are, respectively, the equity of

bank j and the exposure that bank i has with bank j at

2
time t. The above updating equation is used when bank
j has not defaulted in the previous time period, otherwise aij (t + 1) is set to be zero. In such approach it is
also crucial to understand how the time step is defined:
is it a year, a quarter or a minute? The answer is not
irrelevant because one of the findings of Ref. [2] is that,
no matter how small the initial shock is, if the modulus
of the largest eigenvalue of the interbank leverage matrix
a
ij = Eiji is greater than one, at least one bank fails. This
is the equivalent of the butterfly effect for banks which
is clearly unrealistic in actual financial networks. The
main issue relative to Eq. (1) is that it fails to consider
the stochastic nature of the potential loss associated to
nodes with diminished equity. We believe that the most
useful objects of investigation are the probabilities of defaults of the nodes and not the assets. In introducing
our model, we maintain the characteristics of DebtRank:
a monetary value for the centrality measure of a node
and the sensitivity to a distress of the network also in
absence of actual default. In addition to this, our model
uses techniques that are familiar to finance professionals
[25] and its contagion mechanism is intuitive, with the default of a node increasing the probability of default of its
neighbourhood. The introduction of a well-defined unit
of time allows analysing the dynamic of stress propagation and modelling the financial institutions as complex
agents reacting to evolving macroeconomic scenarios.

II.

quantified as:
Ii (t) =

aij (t)j (t)LGDj (t)

(2)

where j (t) is equal to 1 if node j has defaulted at time

t, and is 0 otherwise. We will consider aij (t) = aij as
a constant and the index j in the sum includes all the
nodes that had not been defaulted at the previous times
0, .., t t. The monetary impact on node i would, in
turn, trigger a modification of the total assets and the
thresholds, but also of the probabilities of default, of node
i at the next time, according to the following updating
equations:
Ei (t + t) = max[0, Ei (t) Ii (t)]
Ai (t + t) = max[0, Ai (t) Ii (t)]
P Di (t + t) = f [P Di (t), Ii (t), Ei (t), Ai (t), ...]

(3)

where P Di (t + t) is in general a function f of the probability of default P Di (t), the impact experienced, the
threshold and the total asset at the previous time. In
this paper we will not take into account the dynamics of
LGDi (t). We will set LGDi (t) = 0.6 for each bank i to
be constant in time.
We have established a mapping between probability of
default and change in equity in the context of standard
financial risk management theory [3] using the Merton
model [23]:

THE PD MODEL


In our model, financial institutions are described as the
nodes of a network. Each node i, with i = 1, 2, . . . , N , is
characterised, at time t, by the total asset Ai (t), i.e the
set of anything a financial institution owns and that can
be converted to cash, by a loss given default LGDi (t),
representing the percentage of the total asset that would
be lost in case of default, and by a threshold Ei (t), denoting the capital of i, more precisely the tier1 capital,
which is the capital of the bank that can be used to absorb losses. Furthermore, we associate to each financial
institution i a probability of default per time interval
P Di (t) P Di (t, t). This is a crucial quantity of our
model, and represents the probability that node i defaults in the time interval [t, t + t]. The links of the
network are directed and weighted, and represent credit
relationships, for example loans, among financial institutions. In practice, we set the weight aij of the link from
i to j equal to the exposure of i to the default of node j.
In order to quantify systemic risk, we use a multiperiod simulation process with M time iterations, during
which the nodes can default, triggering an increase of the
probability of default in their neighbourhood as a contagion mechanism. The time step t is chosen coherently
with the definition of P Di (t, t), hence it is a well defined unit of time. In the following computations we will
use t = 1 year. In our model, the monetary impact
on node i due to the defaults of neighbouring nodes is

P Di (t) = 1

ln Ai (t) ln Bi 0.5i2
i


(4)

where is the cumulative gaussian distribution and, for

simplicity, we have set the drift term equals to zero and
considered a period of one year (see Materials and Methods). The total asset volatility i and the total liability
Bi are considered constant during the simulations, with:
Bi = Ai (0) Ei (0)

(5)

Hence Ai (t) can be expressed as Ai (t) = Ei (t) + Bi , and

Eq. (4) provides an updating equation for P Di (t + t)
once the right hand side is updated with the new value
of Ei (t + t) obtained from Eqs. (3). We also set
P Di (t + t) = 1 when the impact Ii (t) on the financial institution i is equal to its tier1 capital Ei (t), i.e to
the maximum monetary loss the institution can tolerate
(see Fig. 1). The procedure that we have just described,
for updating the probabilities of default will be referred
to as the Merton update. We have also explored a Linear
update, i.e. a linear relationship between P Di (t + t)
and the impact Ii (t):


(1 P Di (t))Ii (t)
(6)
P Di (t + t) = min 1, P Di (t) +
Ei (t)
with P Di (t + t) being capped to 1 when the impact
Ii (t) is greater or equal to Ei (t) (see Fig. 1).

3
discounted values of the losses at the different time periods:
Ltot =

M
X

L(t)D(t)

(9)

t=1

FIG. 1: Probability of default P D of a node as a function of

the impact I expressed as a fraction of the capital E. When
the ratio I/E is equal or greater than 1 we set P D = 1 as
the financial institution is insolvent and it will default during
the next time period. The continuous line describes the Linear update while the dots represent the Merton update with
different values of asset volatilities .

In our simulations, at each of the M time periods, the defaults are driven by a stochastic process
(X1 , X2 , . . . , XN ) which is assumed to follow a multivariate gaussian distribution with a correlation matrix
whose elements {i,j } are, for instance, calculated from
the equity returns of financial institutions i and j, obtained from the stock market quotations [19]. According
to Ref. [18] we consider i,j = i, j. In order to reflect
the fact that the average correlation increases during periods of crises, it is possible to use updating equations
such as:
(t + t) = min [1, (t) + ND (t) C (t)]
(7)
P
for the pairwise coefficient , where ND (t) =
j j (t)
is the number of defaulted nodes at time t. The quantity C (t) represents the average correlation increase per
single default at time t and needs to be calibrated (or assumed in a stress scenario). For simplicity, we have not
used Eq. (7) but we have performed simulations with different values of (kept constant during the simulation).
The default of financial institution i at time t (more
specifically in the temporal window [t, t + t]) happens
when the corresponding drawn value xi of random variable Xi in the sampling (X1 = x1 , X2 = x2 , . . . , XN =
xN ) is smaller than 1 (P Di ), with being the cumulative gaussian distribution. If at least a node has defaulted
at time t, we update the variables of the system for the
next time t + t as in Eqs. (3). Defaulted nodes are then
removed. Instead, if no node has defaulted at time t, we
proceed to the following time step and the new sampling
(X1 = x1 , X2 = x2 , . . . , XN = xN ) with the same network and stochastic process parameters. The simulation
is then continued for M temporal iterations.
The loss L(t) for the entire network at time t is calculated as:
X
L(t) =
Aj (t)LGDj (t)j (t)
(8)
j

while the total loss Ltot is obtained by summing up the

where D(t) is the discount factor relative to time t (in

this paper we set D(t) = 1 for each t). We have considered an ensemble of 100000 different Montecarlo realizations of the M = 7 iterations of the stochastic process
corresponding to a total period of 7 years, and we have
calculated distributions and averages of different quantities, such as the losses, over the ensemble. We indicate
with the symbol such averages. The fact that our Montecarlo simulations involve a number of time steps and in
each of them the contagion is spread via a modification
of the probability of default, is a crucial difference with
respect to standard credit risk management techniques.

A.

Stress scenario: PDImpact and PDRank

In our framework, the nodes are characterized

by an initial probability of default PD(t)
(P D1 , P D2 , . . . , P DN ) at time t = 0. Hence, even in absence of any external shock, the system can suffer losses
during the simulations within the considered time frame
of M time periods. The loss distribution so obtained, and
in particular the expected loss Ltot (PD) can be used as
the base-line for comparison with the losses in presence of
stress. Since a distress of the network is described as an
increased probability of default of a set of nodes, PD,
we can introduce the so-called Probability of Default Impact (PDImpact), indicated as C(PD), of the stressing
perturbation PD onto the initial probability of default
PD as:
C(PD) = Ltot (PD + PD) Ltot (PD)

(10)

where the two terms on the right hand side are respectively the average loss of the network in the presence and
absence of the additional stress PD.
Analogously, we can also introduce a node centrality
measure, that we name the Probability of Default Rank,
or PDRank, for assessing the relative importance of each
financial institution. The PDRank of node i is obtained
multiplying the probability of default of node i by the
additional average loss experienced by the network due
to the default of node i:


(11)
P DRanki = P Di Ltot (PDDi ) Ltot (PDIi )
where PDDi is the initial probability vector in which the
probability corresponding to node i has been set to 1 at
t = 0, while PDIi is the initial probability vector where
the probability corresponding to node i has been set to
0 and kept at the value 0 for each time t 0 (the node
cannot default during the simulation). Therefore, the

4
quantities Ltot (PDDi ) and Ltot (PDIi ) represent respectively the average loss, during the simulation, when node
i defaults at time 1, and when node i cannot default (the
average loss that the network would suffer anyway irrespective of the node i). In practice, P DRanki of node
i measures the expected loss due to node i. As the
already known DebtRank, it is expressed as a monetary
value and can be used to rank the nodes in terms of their
systemic risk.
A further characterization of a network, which we
name P DBeta, can be obtained by quantifying the sensitivity of the system to a percentage increase of all the
initial probabilities of default. Assuming an approximate
linear relationship between the PDImpact C(PD ) obtained for an increase of the probabilities of default
PD PD x/100 and the percentage of increase x,
we can define P DBeta as follow:
P DBeta =

C(PD )
x

(a) Merton update

(12)

In this way P DBeta represents the variation of PDImpact for a unitary percentage variation of the probabilities of default.

(b) Linear update

Results

We have applied our model to analyse the data collected by the European Banking Authority (EBA) relative to the European global systemically important banks
(gsib), and we have used a new algorithm to infer the
network of exposures from the incomplete data provided
(see Materials and Methods). The initial values of the
probabilities of default have been obtained from public information about the credit rating of the banks and
from statistics available on the Fitch website (see Materials and Methods). The results in this section should
be considered as an academic exercise to illustrate the
characteristics of the model as we do not have the exact
adjacency matrix of exposures and a number of approximations and assumptions have been made. Also it is
clearly unreasonable assuming that the banks or the regulators would not react after the first defaults (replenishing their tier1 capital for example). In the following,
where not specified we use an average correlation = 0.5.

B.

Two regimes: weak and strong contagion

The distributions of the total loss Ltot experienced by

the network under different values of average correlations
and different values of the thresholds are shown respectively in Fig. 2 and Fig. 3. We say that the system
is in a strong contagion (as opposed to weak contagion) regime if its ability to propagate the stress on the
network affects the loss distribution, depleting the intermediate losses in favour of the extreme end of the tail.

(c) Merton update with thresholds lowered by 50%

FIG. 2: Distributions of the network total loss for different

values of the average correlation . In panel (a), higher correlations increase the losses with the Merton update model.
This is in contrast with the Linear update reported in panel
(b), where higher correlations correspond to lower losses.
Panel (c) shows a similar behaviour as panel (b), using the
Merton update but reducing all the thresholds by 50 %.

Fig. 2(b) and and Fig. 3(b), relative to the Linear update, present strong contagion characteristics. In particular Fig. 2(b) shows that lower average correlation corresponds to more pronounced losses as it is more likely to
have at least one default during the first time periods and
subsequently the loss is amplified by the contagion. The
Merton update model in Fig. 2(a) does not show strong
contagion effects with the available data. This does not
mean that they cannot appear under particular circumstances. For example, the distribution corresponding to
thresholds reduced by 50% or 90% in Fig. 3(a) clearly
shows the depletion of the loss distribution in the middle
with a marked increase in the tail. As a further example,
as shown in Fig. 2(c), when the thresholds are reduced at
half of their values, also the system with Merton update
shows increasing losses at lower value of average .

(a) Merton update

(a) Merton update

(b) Linear update

(b) Linear update

FIG. 3: Distributions of the network total loss for different

values of the thresholds. When the thresholds are reduced by
50% or 90% the loss distributions accumulate on the far right
of the tail both for the Merton update in panel (a) and for
the Linear update in panel (b)

FIG. 4: Approximate linear dependence between PDImpact

C(PD ) obtained for an increase of the probabilities of default PD PD x/100 and the percentage of increase x.
In the analysed network , the average loss increase per 1% increase in the probability of default is about 3.5 and 9 billion
EUR respectively for the Merton and for the Linear update.

Fig. 4 confirms an approximate linear relationship between PDImpact and a percentage increase of the initial probabilities of default, allowing the definition of the
measure PDBeta (Eq. (12)) that can be used, together
with the expected loss Ltot , to gauge the riskiness of a
network. Defining the global asset of the network as
PN
Aglob =
k=1 Ak , we have found Ltot /Aglob = 0.93%
and P DBeta/Aglob = 0.0124% for the Merton update,
and Ltot /Aglob = 5.125% and P DBeta/Aglob = 0.0318%
for the Linear update.

C.

The critical nodes of the network

We can now analyse the relative contribution of the

nodes to the systemic risk of the network. Table I reports
the values of PDRank in million of EUR, obtained using respectively the Merton and the Linear update. The
ranking of the most important nodes is different in the
two cases and the corresponding values can vary by more
than one order of magnitude for nodes with a high probability of default such as BFA with P D = 0.0116 and
MPS with P D = 0.0093. These nodes can act as a catalyst for a chain reaction of losses especially in a strong
contagion regime: relatively small losses can have a dramatic effect on the probability of default of the impacted
nodes and this explains why they are at the top of the
DebtRank table in the Linear update case. The ranking
implied by PDRank is different from the one that takes

into consideration the total asset of the financial institutions (as in a too big to fail approach). This is evident
as the PDRank definition includes the probability of default, which is not related to the total asset. We can investigate if PDRank can be explained by the probability
of default multiplied by the total asset. Fig. 5 shows that
this is not the case even if there is definitely a positive
correlation. It is interesting to note that BFA and MPS
are well above the regression line in case of the Linear
update (Fig. 5b), which reflects once again the increased
role of the probability of default in a strong contagion
regime.

III.

CONCLUDING REMARKS

The model described in this paper uses different types

of information regarding the financial institutions: correlation structure, probabilities of default and network of
exposures. It allows following the evolution in time of
the network under different stress scenarios, using multi
period Montecarlo simulations. In this paper we focused
our attention to average quantities to characterized the
riskiness of the network, such as expected loss and the
slope of the expected loss vs a percentage increase of the
probabilities of default (PDBeta). However our model
allows obtaining the entire loss distribution and other
statistics (e.g. quantiles) could be more appropriate for

6
PD Threshold Total Asset
Bank PDRank
0.001
70378
2252752 BNP Paribas
10784
0.001
59081
1940282
Barclays
6728
0.0017
45499
1034421
Unicredit
4866
0.001
51250
1410547
RBS
3430
0.001
25123
655686 Commerzbank
3254
0.001
70719
1723006 Credit Agricole
3003
0.001
64250
1455593
Santander
2759
0.001
63397
1659337 Deutsche Bank
2730
0.0116
11879
234816
BFA
2139
0.001
49969
1336600
BPCE
1962
0.0093
6608
201385
MPS
1919

(a) Merton update

(a) PDRank - Merton update

PD Threshold Total Asset

Bank PDRank
0.0093
6608
201385
MPS
82209
0.0116
11879
234816
BFA
75002
0.0017
45499
1034421
Unicredit
26010
0.0017
38247
695873 Intesa Sanpaolo
20507
0.001
70378
2252752
BNP Paribas
15636
0.001
59081
1940282
Barclays
15512
0.001
51250
1410547
RBS
15393
0.001
63397
1659337 Deutsche Bank
15313
0.001
25123
655686 Commerzbank
15311
0.001
64250
1455593
Santander
15217
0.001
70719
1723006 Credit Agricole
15204
(b) PDRank - Linear update

TABLE I: Top twelve nodes ordered by PDRank in the network of global systemically important banks of the European
Union. The data is relative to the end of 2014 which is time
0 in our simulations.

particular investigations. The nodes can be ranked in a

natural way with respect to their contribution to the systemic risk using the centrality measure PDRank. The
contagion propagation is easy to understand as it is linked
to an increase of the probability of default of a node due
to the default of its neighbours. We have also introduced
an algorithm to re-create a network of individual exposures given the information of the total intra-node assets
and liabilities for each node. A strong contagion regime
has been identified, characterized by larger losses at lower
average correlation between nodes and by a depletion of
the loss distribution at intermediate losses in favour of
a fatter tail. The financial network considered does not
present strong contagion effects when using the Merton
update. However we have seen that such effects can appear when the banks are not sufficiently capitalized (i.e.
thresholds are low). Furthermore we have kept the asset
volatility constant in the Merton model. In periods
with extreme volatility, would be bigger and the P D
calculated with the Merton update (Eq. (4)) could increase significantly, moving the system toward the strong
contagion regime.

(b) Linear update

FIG. 5: PDRank of a financial istitution is shown as a function the probability of default of the corresponding node times
its total asset. Panel (a) and (b) refer to the Merton and the
Linear update respectively. While there is a positive correlation, PDRank cannot be explained completely with a linear
regression and the differences can be thought as due to network effects.

IV.

MATERIALS AND METHODS

European global systemically important banks.

As part of its mandate, the European Banking Authority
collect data annually from the global systemically important banks (gsib) in the European Union and publish the
results in their website www.eba.europa.eu. We have
chosen the data from the year 2014. The data set contains the fields Intra-financial system assets and Intrafinancial system liabilities that we use in our model to
recreate the individual exposures using the algorithm described in the next paragraph. The field Total exposures
provides a proxy for the total assets (Ai (t)). The tier1
capital has been obtained from another study performed
by EBA in cooperation with European Systemic Risk
Board (ESRB): The EU-wide stress test, that aims at
assessing the resilience of financial institutions to adverse
market developments.We have selected the Banks that
were in both exercises and we identified 35 institutions.
The initial probability of default has been obtained from
the table Financial Institutions Average Annual Transition Matrix: 1990-2014 in the document 2015 Form
NRSRO Annual Certification obtained from Fitch website www.fitchratings.com.
Inferring the network. We describe a new algorithm to infer the network from incomplete data. In the
literature, a maximum entropy algorithm [30] has often

7
been used but it is known that it might not represent
the best choice for recreating a realistic interbank network [24] and different alternatives have been proposed
[8][15][9]. We want to capture the fact that small financial institutions are more inclined to have connections
with a small number of bigger banks. The level of exposure tends to be above a certain minimum value as
the creation of a credit relationship involves a maintenance cost. This was already addressed by Anand et al.
[1] but here we propose an alternative algorithm that we
find more intuitive and that allows controlling over the
minimum exposure amount and the degree of attraction
between smaller nodes and bigger ones. The main idea
is to match asset with liabilities, building the adjacency
matrix in steps: 1) The smaller borrower nodes choose
first where to get the money from; 2) The lender (a different node) is chosen randomly with a probability that
is proportional to its remaining assets to the power of
alpha (alpha being the parameter for tuning the degree
of attraction between heterogeneous nodes). 3) The loan
amount is chosen as a percentage of the total liabilities
of the borrower node and represents the minimum exposure that it is convenient to exchange, constrained by
the residual assets of the lender and the residual liabilities of the borrower. 4) The adjacency matrix and the
residual asset and liabilities amount are updated. 5) The
process continues till all the assets are matched with all
the liabilities. 6) If at the end remains one node that can
borrow money only from itself, the procedure re-routes
some of the previous loans so that the adjacency matrix

is completed with zero values on the diagonal.

Merton Model. The Merton model can be used to
evaluate the probability of default of a company i described as having a single liability Bi (t) = Ai (t) Ei (t)
in terms of a bond issued and expiring at time T = t+t.
The asset Ai of the company is thought as following a lognormal random process with drift i and volatility i . A
default occurs if during a simulation the asset Ai (t) falls
below the value Bi (T ) at time T . Assuming Bi (t) = Bi
as a constant, it is possible to calculate the probability
of default as:

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P Di (t) = 1

ln Ai (t) ln Bi + (i 0.5i2 )t

i t


(13)

is the cumulative gaussian distribution. To simplify

we assume i = 0 and t = 1 year. Having P Di (0),
Ai (0) and Ei (0) it is possible to calculate Bi and, inverting Eq. (13), i . We make the assumption that i
doesnt change during the simulation. It is then possible to use Eq. (13) to update the probability of default
P Di (t) given the new values of Ai (t) and Ei (t). The
assumption of constant i is not completely satisfactory
as it is reasonable to expect that the volatility increases
when the company approaches the default. It is possible
to devise a more complex implementation of the model
that includes a dynamics for i (t).
Acknowledgments

We are grateful for discussions with Alessandro Fiasconaro and Neofytos Rodosthenous

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