Too Interconnected to Fail: Financial Network of CDS and Other Credit Enhancment Obligations of US Banks

This section will focus on a recent working paper titled: Too Interconnected To Fail:  Financial Networks of CDS and Other Credit Enhancement Obligations of US Banks; by Sheri Markose, Simone Giansante, Mateusz Gatkowski and Ali Rais Shaghaghi. This paper was prepared for presentation at the ECB Workshop on "Recent Advances in Modelling Systemic Risk Using Network Analysis", 5 October 2009.

 

 

Abstract

 

Credit default swaps (CDS) which constitute up to 98% of credit derivatives have had a unique, endemic and pernicious role to play in the current financial crisis. However, there are few in depth empirical studies of the financial network interconnections among banks and between banks and non-banks involved as CDS protection buyers and protection sellers. The ongoing problems related to technical insolvency of US commercial banks is not just confined to the so called legacy/toxic RMBS assets on balance sheets but also because of their credit risk exposures from SPVs (Special Purpose Vehicles) and the CDS markets. The dominance of a few big players in the chains of insurance and reinsurance for CDS credit risk mitigation in banks’ assets has led to the idea of “too interconnected to fail” resulting, as in the case of AIG, of having to maintain the fiction of non-failure in order to avert a credit event that can bring down the CDS pyramid and the financial system. This paper also includes a brief discussion of the complex system Agent-based Computational Economics (ACE) approach to financial network modeling for systemic risk assessment. Quantitative analysis is confined to the empirical reconstruction of the US CDS network based on the FDIC Quarter 4 data in order to conduct a series of stress tests that investigate the consequences of the fact that top 25 US banks account for $16 tn of the $34 tn gross notional value of CDS reported by the BIS and DTCC for the end of 2008. The May-Wigner stability condition for networks is considered for the hub like dominance of a few financial entities in the US CDS structures to understand the lack of robustness. We provide a Systemic Risk Ratio for major US banks for their CDS activity in terms of the loss of aggregate core capital. We also compare our stress test results with those provided by SCAP (Supervisory Capital Assessment Program.) A multi-agent simulator for the stress tests for CDS financial networks for US banks will be demonstrated.

 

Working Paper

#683, March 2010  University of Essex, Department of Economics Working Paper

Author: Sheri Markose, Simone Giansante, Mateusz Gatkowski and Ali Rais Shaghaghi 
Title: Too Interconnected To Fail: Financial Contagion and Systemic Risk in Network Model of CDS and Other Credit Enhancement Obligations of US Banks (pdf version)

 

 

Simulator