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Section: Research Program

Contagion modeling and systemic risk

Participants : Benjamin Jourdain, Agnès Bialobroda Sulem.

After the recent financial crisis, systemic risk has emerged as one of the major research topics in mathematical finance. The scope is to understand and model how the bankruptcy of a bank (or a large company) may or not induce other bankruptcies. By contrast with the traditional approach in risk management, the focus is no longer on modeling the risks faced by a single financial institution, but on modeling the complex interrelations between financial institutions and the mechanisms of distress propagation among these. Ideally, one would like to be able to find capital requirements (such as the one proposed by the Basel committee) that ensure that the probability of multiple defaults is below some level.

The mathematical modeling of default contagion, by which an economic shock causing initial losses and default of a few institutions is amplified due to complex linkages, leading to large scale defaults, can be addressed by various techniques, such as network approaches (see in particular R. Cont et al. [60] and A. Minca [79]) or mean field interaction models (Garnier-Papanicolaou-Yang [72]). The recent approach in  [60] seems very promising. It describes the financial network approach as a weighted directed graph, in which nodes represent financial institutions and edges the exposures between them. Distress propagation in a financial system may be modeled as an epidemics on this graph. In the case of incomplete information on the structure of the interbank network, cascade dynamics may be reduced to the evolution of a multi-dimensional Markov chain that corresponds to a sequential discovery of exposures and determines at any time the size of contagion. Little has been done so far on the control of such systems in order to reduce the systemic risk and we aim to contribute to this domain.