Risk trading, network topology and banking regulation
Quantitative Finance, 3 (4):
306--319 (Aug 1, 2003)DOI: 10.1088/1469-7688/3/4/307
Abstract
In the context of understanding the nature of the risk transformation process
of the financial system we propose an iterative risk-trading game between
several agents who build their trading strategies based on a general utility
setting. The game is studied numerically for different network topologies.
Consequences of topology are shown for the wealth time-series of agents, for
the safety and efficiency of various types of networks. The proposed setup
allows an analysis of the effects of different approaches to banking regulation
as currently suggested by the Basle Committee of Banking Supervision. We find a
phase transition-like phenomenon, where the Basle parameter plays the role of
temperature and system safety serves as the order parameter. This result
suggests the existence of an optimal regulation parameter. As a consequence a
tightening of the current regulatory framework does not necessarily lead to an
improvement of the safety of the banking system. Moreover, we show that banking
systems with local risk-sharing cooperations have higher global default rates
than systems with low cyclicality.
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