Modeling Financial Networks: a feedback approach

Thiago Silva (), Michel Alexandre and Benjamin Tabak

No 438, Working Papers Series from Central Bank of Brazil, Research Department

Abstract: We study cascade of failures in multilayer financial networks incorporating contagion feedback effects among different economic agents. We develop a flexible framework that allows for the evaluation of systemic risk in financial networks and demonstrate that the model converges to a unique fixed point. We design a financial accelerator engine to model the feedback effect between the real and the financial sectors of the economy by using contagion transmission channels such as loan defaults, bank credit crunches, deposit withdrawals, and deposit defaults. We illustrate the model using data on Brazilian bank-bank and bank-firm loans. We show that the contagion feedback effect – which accounts for second and higher-order rounds of stress propagation and is overlooked by the existing literature – is economically significant. This finding suggests that models that were developed up to date may be severely underestimating systemic risk.

Date: 2016-05
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