Financial Network and Systemic Risk -- A Dynamic Model

Abstract

We develop a dynamic model to study the systemic risk of the banking network, so as to study the dynamics of bank defaults. In contrast to the existing literature, we show that while the possibility of contagion is determined by interconnectedness of the financial network, whether a financial crisis can occur depends on the profile of the liquid assets of the banks in the system. Based on the dynamic model, we introduce a time to crisis index that allows us to predict the occurrence of a financial crisis. We then provide an intuitive measure of systemic risk. To illustrate the potential usefulness of our model, we provide an analysis of the system of twenty two German banks. We show how many of the banks are fundamentally weak, where the contagion effect may arise from, how strong the contagion effect is, and how significant the systemic risk is.