Balance-sheet Network Analysis

Jorge A Chan-Lau

Financial markets are rapidly evolving in terms of product innovation, technology adoption and geographical and sectoral integration. This rapid evolution has contributed to extensive and stronger interconnections across markets and institutions, leading to a global financial system that is robust but at the same time fragile (Haldane, 2009). On the one hand, interconnections can help to buffer the system against relatively mild shocks since they allow institutions to diversify risks across markets and counterparties. On the other hand, interconnections can amplify severe shocks and serve as spill-over conduits. The trade-off between risks to financial stability and the benefits from risk diversification depend on the magnitude of the shocks, the capitalisation level of individual financial institutions and the extent of interconnection. Benefits tend to offset the risks the better capitalised financial institutions are, and vice versa.

From a downside risk perspective, cross-market and cross-institution linkages create too-connected-to-fail (TCTF) or too-interconnected-to-fail (TITF) risk. A simple characterisation of the TCTF risk is that the failure of one institution could