Taming financial systemic risk: models, instruments and early warning indicators

In recent decades, most advanced and developing economies have suffered—or are still suffering—from profound and repeated crises. The literature has reflected on the determinants of these perturbations by placing particular emphasis on the malfunctioning of either the real or financial sphere of the economy. The main research question has been to understand whether it was the real economy that perturbed finance sectors or, alternatively, the financial/credit market that depressed real production. Whatever the direction of the causality nexus and, consequently the origin of the attack, with some studies identifying the direction from real markets to financial sectors (see Bernanke and Gertler 1989; Greenwald and Stiglitz 1993; Delli Gatti et al. 2012) and others reversing it (see Christiano and Ikeda 2011; Brunnermeier et al. 2012), what is certainly undoubted is the self-reinforcing interaction between the two sectors, which translates into booms followed by busts. In light of this, part of the literature has not focused as much on the origin of crises, but rather on the mechanisms of shock propagation. In this regard, many studies have shown that a combination of forces is needed to generate shock transmission. Specifically, the literature on contagion has shown that agents’ interaction and the emerging network topology are key ingredients for the spread of systemic risk (see, for instance, Lux 2016; Lux and Montagna 2017). The interaction has in fact been recognized as generating two opposing effects: risk sharing, which decreases with connectivity, and systemic risk, which in contrast, increases with linkages (see, for instance, Allen and Gale 2000; Battiston et al. 2007, 2012a, b; Grilli et al. 2014; Iori et al. 2006; Mazzarisi et al. 2020; Tedeschi et al. 2012). Many other studies have confirmed the nonlinearity of this relationship. This body of work has also shown that other factors must be added to generate the catastrophic effects that characterized the 2007 financial collapse, namely the agents’ heterogeneity and financial fragility (see Aymanns et al. 2016; Bardoscia et al. 2017; Caccioli et al. 2011, 2014, 2015; Lenzu and Tedeschi 2012). In fact, as reported by Berardi and Tedeschi (2017) “on the one hand, the possible emergence of contagion depends crucially on the degree of heterogeneity. Indeed, when the agents’ balance sheets are heterogeneous, banks are not uniformly exposed to their counter-party. Therefore, if contagion is triggered by the failure of a big bank, which represents the highest source of exposure for its creditors, the situation is certainly worse than when agents are homogeneous [...]. On the other hand, the probability of default in credit markets is strictly linked to the presence of highly leveraged agents [...]. Indeed, when variations in the level of financial robustness of institutions tend to persist in time or to get amplified, financial linkages among financially fragile banks represent a propagation channel for contagion and a source of systemic risk.” Interestingly enough, this second element is very close in spirit to the Minskyan financial instability hypothesis, where endogenous shifts in the degree of financial fragility of agents generate business fluctuations and, possibly, the materialization of bankruptcy cascades (see Minsky 1964; Ferri and Minsky 1992)