Understanding Systemic Risk in Financial Markets

Power grids, populations, large companies, banking systems, and other collections of numerous and highly interconnected elem-ents are subject to what George Papanicolaou of Stanford University calls “systemic risk.” As he explained in an invited talk at the 2012 SIAM Annual Meeting, each such system is susceptible to a type of “contagion” that, though triggered by seemingly unimportant events, is capable of destroying the whole if allowed to spread unchecked. Early in the talk, Papanicolaou showed a schematic diagram of the global financial network (see Figure 1). Of course, every country has a financial market of some magnitude, and every such market trades (or can trade) with any other. Many markets and channels, however, are either too small or too faint to show up in a roughly quantitative diagram. It is easy to imagine a similar diagram in which the spheres would represent major international banks, and the thickness of the connecting edges would represent the level of (net) indebtedness of one to another. In that case the edges would be directed, and the diagram could be used to assess the risk that the insolvency of even a few of the lesser institutions might spread throughout the global banking system. If the data were sufficiently reliable and up to date, it could even identify the banks best reinforced against the spread of insolvency.