What Financial Regulators Can Learn from Network Theory

When regulators seek to identify systemically important financial institutions (SIFIs), they tend to focus on an institution’s size and connectedness. But this approach mises an important dimension of systemic risk, according to Imre Kondor, Stefano Battiston, Giorgio Fagiolo, and Alan Kirman.

This team of economists and physicists emphasizes that systemic risk is a complex and collective problem, not something that can be read off the balance sheet of individual units. They take into account all kinds of indirect influences – managers in business schools and quants at trading desks comprise a social network whose members consume more of less the same information – to investigate how strong correlations can arise between seemingly unrelated institutions at dispersed areas of a network. Strongly correlated clusters of institutions, they say, are what regulators need to watch out for.