Connecting the Dots: Econometric Methods for Uncovering Networks with an Application to the Australian Financial Institutions

This paper connects variance-covariance estimation methods, Gaussian graph- ical models, and the growing literature on economic and nancial networks. We construct the network using the concept of partial correlations which captures direct linear depen- dence between any two entities, conditional on dependence between all other entities. We relate the centrality measures of this network to shock propagation. The methodology is applied to construct the perceived network of the publicly traded Australian banks and their connections to the domestic nancial sector, real economy, and international mar- kets. We nd strong links between the big four Australian banks, the nancial services sector and the other sectors of the economy and determine which entities play a central role in transmitting and absorbing the shocks.