Team studies the innermost circle of the financial crisis

The innermost circle of the financial crisis
At the peak of the financial crisis the network of American banks formed a very fragile system (Image: iStockphoto)

( -- “Too central to fail” instead of “too big to fail”: whether banks pose a risk to the financial system when they get into distress has more to do with their level of networking than with their size. Economic researchers at ETH Zurich have developed a method to deduce the “systemic importance” of banks from their complex connections within financial networks.

Between 2008 and 2010 a total of 22 formed the innermost circle of the financial crisis. They were so intensely connected with each other through credit relationships, mutual equity investments and financial dependencies that the distress of any single one of them could endanger the entire financial system. In November 2008, the emergency loans granted to these banks by the American to protect the American financial system from collapse amounted to a total of USD 804 billion.

The interdependencies among these 22 banks were likely so strong that a small shock to the system as whole could get amplified into a systemic default. Thus the US Federal Reserve could not have allowed them to fail without creating serious consequences for the economy.

This is the conclusion reached by four economics researchers at ETH Zurich in a study published on 2 August 2012 by the online and open access journal Scientific Reports. This is a primary research publication from the publishers of Nature.

A fresh impetus

The paper by the ETH Zurich researchers injects fresh impetus into the debate regarding the systemic importance of banks that are “too big to fail”. A bank becomes systemically important, or “too big to fail”, when its services are irreplaceable and its insolvency would cost the national economy more than its rescue by the state. However, a bank’s size is only one indicator of its importance for the financial system.

Even small banks can pose systemic risks if they are closely networked with other financial institutions. However, the identification of such networking risks and interdependent credit risks presents major challenges for science, business and the authorities concerned. For this reason, the European Commission has launched the scientific project “Forecasting Financial Crisis (FOC)”. FOC is financed by the FET OPEN Scheme (“Future and Emerging Technologies Open Scheme”). Its research topic is to understand and possibly forecast systemic risk and global financial instabilities. 

The FOC-funded “too central to fail” approach developed by Stefano Battiston, Michelangelo Puliga, Rahul Kaushik and Paolo Tasca at the ETH Zurich Chair of Systems Design, together with Guido Caldarelli of IMT Lucca (Italy), is also pointing in this direction. Their strategy is doubly innovative: on the one hand, it is based on original data from the Federal Reserve, while on the other hand, the ETH Zurich researchers are analysing the Fed data using a newly-developed network research method for the first time.

Furthermore, the Swiss National Science Foundation (SNSF) is funding another project of this Chair on non-regulated over-the-counter (OTC) markets and systemic risk in financial networks. The results of the methodology can be seen interactively at .

Emergency loans used as a data source

The Federal Reserve data originate from the “emergency loan program” from 2007 to 2010, through which the Fed provided “cheap” money to financial institutions in the USA that were acutely at risk of defaults. At the height of the crisis, the total amount of loans granted climbed to an astonishing USD 1.2 trillion.

The Federal Reserve published the figures after the US Supreme Court granted the Bloomberg business and financial information and news company the right to inspect the data, since the American financial system had, after all, been restructured using public funds. 

The data sets from the Federal Reserve and Bloomberg document the residual outstanding debts and the market capitalisation of a total of 407 financial institutions that borrowed emergency loans from the Fed. The size of the loans provides an indication of a bank’s individual debt over equity ratio and of any potential distress or defaults.

The assessment of the Federal Reserve data showed that, although the various banks got into difficulties at different times, around 30 banks reached the peak of their emergency situation simultaneously at the height of the crisis. Considered over the entire duration of the emergency loan program, it also became apparent that the number of top borrowers at any given moment hovered around a figure of 20.

The ETH Zurich researchers then turned their focus towards those 22 institutions that had received more than USD 5 billion in emergency loans on average over the entire crisis period. This circle of top borrowers from the Federal Reserve also included the US-based branches of the two major Swiss banks UBS and Credit Suisse, which had averaged outstanding debts to the Fed amounting to USD 13.89 billion (UBS) and USD 13.29 billion (CS) between 2008 and 2010. This put them in 6th and 7th position among the top borrowers.

Google principle used to examine Federal Reserve data

The main new feature in the ETH Zurich economists’ approach is their methodology: to discover how the distress of a tightly networked financial institution impacts on other banks and spreads through the network, they combined the finance notion of balance-sheet contagion with methods from network science, including the principle behind the well-known “PageRank” algorithm. This algorithm is at the heart of the Internet search engine “Google”. The score of a webpage depends, recursively, on how many other important webpages point to that webpage.

In a similar way, in the “DebtRank”, introduced by the ETH Zurich researchers, the systemic importance of an institution is higher if its distress affects other systemically important institutions. This recursivity can be solved mathematically yielding a number measuring the fraction of the total economic value in the network that is potentially affected by the distress or the default of an institution.

“Many economists regard today financial systems as complex networks, in which the financial institutions constitute the nodes and the links between the nodes represent the banks’ financial dependencies,” explains Stefano Battiston. The researchers also drew on earlier papers by the Chair of Systems Design, which examined the global network of corporate control.

The study enables them to estimate how central a bank’s position is within the , and what risk it poses. In this sense, “DebtRank” serves as an indicator of a bank’s level of networking and thus its systemic importance.

Explore further

A plan for better banking: Researchers propose model of systemwide diversification

More information:
Battiston S, Puliga M, Kaushik R, Tasca P, Caldarelli G (2012). DebtRank: Too Central to Fail? Financial Networks, the FED and Systemic Risk. Scientific Reports, published online 2 August 2012. doi: 10.1038/srep00541

Battiston S, Delli Gatti D, Gallegati M, Greenwald B, Stiglitz JE (2012). Liaisons dangereuses: Increasing connectivity, risk sharing, and systemic risk, Journal of Economic Dynamics and Control, 36 (8): pp. 1121-1141, doi: 10.1016/j.jedc.2012.04.001

Battiston S, Delli Gatti D, Gallegati M, Greenwald B, Stiglitz JE (2012). Default cascades: When does risk diversification increase stability?, Journal of Financial Stability, 8 (3): pp. 138-149, doi: 10.1016/j.jfs.2012.01.002

Vitali S, Glattfelder JB, Battiston S (2011). The Network of Global Corporate Control. PLoS ONE 6(10): e25995. doi:10.1371/journal.pone.0025995

Journal information: Scientific Reports , Nature , PLoS ONE

Provided by ETH Zurich
Citation: Team studies the innermost circle of the financial crisis (2012, August 3) retrieved 23 September 2019 from
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User comments

Aug 03, 2012
One would think an entity of this magnitude would be handled by no one but the government, however, the Federal Reserve is not owned by the government.According to Federal, it is an independent entity operating under the authority of Congress but not subject to it.Sounds pretty good until you dig a little deeper.Federal Reserve stock is owned by private banks, which are not allowed to sell the stock, but which pay dividends of 6 percent a year.When the government needs money, it goes to the Fed. These banks decide whether or not to lend the money to the government at interest, which it will eventually have to pay back to the non-profit Fed.The Fed may not profit, but the banks that hold stock do. Where else would the 6 percent come from?
Banks profit from loans, especially when those loans aren't paid off in time and interest begins to compound.Most Americans are rational 60 percent of the time, they are rational every time and rational people realize the current system

Aug 03, 2012
The federal reserve is a govt owned bank, period.
The fault will ALWAYS lie at the feet of the socialists until they deregulate enabling free market money.

Aug 03, 2012
"Since the beginning of recorded history, governments have had an insatiable desire to consume wealth. Kings and princes, tyrants and democratically elected representatives have never run out of ideas on ways to spend what others have produced and earned. And when governments have discovered that no further wealth can be extracted by means of taxation, they have resorted to the debasement of the currency."
"in the era of "high tech," governments merely add to the money in the economy by pushing a button on the computer vast sums of checkbook money instantly appear on the balance sheet.

This is what makes a monopoly over the power to create money so valuable to governments. Since money, as the general medium of exchange, is readily and willingly accepted by every member of the society, the control of money enables governments to have access to the society's wealth without having first produced anything to acquire that money in exchange."

Aug 03, 2012
"governments have rationalized this process. They have declared that their purpose is to stabilize the economy, guarantee full employment, and assure a balanced financial environment. In 1913, the U.S. government established a central bank the Federal Reserve System to do this job. Its record speaks for itself a "great depression" in the 1930s, a series of economic booms and recessions of various frequency and duration in the post-World War II era, and unending inflation for five decades. By their fruits you shall know them.

Government monopoly and control over money has been an economic and social disaster. "
{for the people, not the govt}

Aug 03, 2012
The Exclusive legal right to counterfeiting money (fiat currency with nothing behind it) was given to a private Cartel of banks in 1913. I The Federal reserve is neither an arm of the government nor is it private. It is a hybrid. It is an association of the large commercial banks which has been granted special privileges by Congress A more accurate description would be simply that it is a Cartel protected by federal law It originally was a hundred year charter but in 1930 during the great depression caused by them, they had the law amended to "in perpetuity" Because all fiat currency in history has always collapsed. . The money supply will continue to expand, inflation will continue to roar, and the nation would continue to die. Issuing money without gold or silver backing violates the constitution. They are not subject to the law. It should be abolished. They are not independent of the government. they have taken over the government.
It is incapable of accomplishing its stated ob

Aug 06, 2012
Nope. As poster #1 stated, it is independently owned and run.

"The federal reserve is a govt owned bank, period." - RyggTard

Why do you feel a need to lie about it Tard Boy?

Nope, the Federal Reserve was established by the 1913 Federal Reserve Act from congress and signed into law by an academic theoretician President Woodrow Wilson. He later admitted he screwed up by signing the bill into law. This was all unconstitutional ofcourse because the constitution only grants CONGRESS the right to regulate the our currency and not a seperate and less accountable institution. It's always the utopian statists who come up with the idea of consolidating MORE power and screwing everything up everMORE. A decade and half later we had the depression as a result of artificial interest rate decisions from the Fed. You got anymore personal insults VD?

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