Restructuring financial networks to reduce systemic risk

Research by the IIASA Advanced Systems Analysis Program shows that the Basel III international regulatory framework for banks will not reduce systemic risk in the financial sector as planned. The results suggest that regulations should instead aim to increase the resilience of financial networks by restructuring them.

A resilient banking sector is a necessary condition for achieving sustained economic growth. The Basel III regulatory framework for banks is a new set of international banking regulations that were proposed after the financial crisis of 2007-2008, which aims to reduce the risk of a similar crisis in the future.  The regulations, which are currently under intense discussion, would set higher requirements for bank capital and liquidity reserves and introduce capital surcharges for systemically important banks, that is, those that are “too big to fail.”

One important aim of the Basel III framework is to reduce the risk of system-wide shocks in the financial sector. It is therefore essential that Basel III address the problem of systemic risk in the financial system in an appropriate way.

However, a recent study by IIASA researchers [1] showed that the capital surcharges would have to be much higher than those currently set to be effective, which would in turn lead to a severe loss of efficiency in the financial system.

The research is based on a state-of-the-art agent-based model of a financial system and the real economy developed earlier [2][3]. Using the model, a series of numerical experiments, simulating different types of regulations and their impacts on risk and resilience in the financial system, were performed. The researchers found that replacing the currently proposed Basel III regulations with different regulation schemes that aim to re-structure financial networks, would be much more effective in increasing resilience while avoiding the loss of efficiency in markets. Such regulations could include smart transaction taxes based on the level of systemic risk, which IIASA researchers proposed in an earlier study [2] to reshape the topology of financial networks.

The study further highlights how important data-driven agent-based modeling has become as a tool to help identify the unintended consequences of regulations, and propose more effective solutions. As the international banking system is complex and intricately connected, it is important to analyze how regulations will affect financial networks from a systemic perspective in order to draft intelligent regulations.

References

[1] Poledna S, Bochmann O, & Thurner S (2017). Basel III capital surcharges for G-SIBs are far less effective in managing systemic risk in comparison to network-based, systemic risk-dependent financial transaction taxes. Journal of Economic Dynamics and Control 77: 230-246.

[2] Poledna S & Thurner S (2016). Elimination of systemic risk in financial networks by means of a systemic risk transaction tax. Quantitative Finance: 1-15.

[3] Klimek P, Poledna S, Farmer JD, & Thurner S (2015). To bail-out or to bail-in? Answers from an agent-based model. Journal of Economic Dynamics and Control 50: 144-154.