Using Network Theory to Understand the Interconnectivity of Financial Risk

For today’s regulators, systemic risk remains a major issue. Tracing the connections between financial institutions and understanding how different mechanisms of financial contagion might flow through the system is complex.

Modern finance is a collective of the activities of tens of thousands of individual enterprises, all interacting in a “living” system. Today, nobody truly understands this system. It is organic and market-driven, but the fundamental processes that drive it occasionally collapse in a financial crisis that affects us all.

The increasing risk of financial contagion in the financial industry has triggered a new discipline of research – called “network theory in financial risk management” – which is quickly gathering pace. These valuable studies aim to identify and analyze all possible connections between financial institutions, as well as how their interconnectivity can contribute to crisis propagation.

Later this month, will launch the Journal of Network Theory in Finance. This journal will compile the key papers of financial risk studies worldwide to provide industry participants with a balanced view of how network theory in finance can be applied to business.

Papers from the inaugural edition of the new journal will be showcased on September 23 at the Financial Risk & Network Theory conference, which is hosted by the Centre for Risk Studies at the University of Cambridge. I will be presenting a keynote on how catastrophe modeling methodologies can be applied to model financial risk contagion.

Our financial institutions are connected in a multitude of ways. For example, by holding similar portfolios of investments, using common settlement mechanisms, owning shares in each other’s companies, and through inter-bank lending.

As the interconnectivity of the world’s financial institutions and markets deepens, financial risk managers and macro-economic planners need to know the likelihood and severity of potential future downturns, particularly the “tail” events of economic catastrophe. Companies must continually understand how they are exposed to the risk of contagion; many were surprised by how fast contagion spread through the financial system during the 2008 credit crunch.

The regulator’s role in limiting the risk of future financial crises includes identifying Systemically Important Financial Institutions (SIFIs) and understanding what aspects of a SIFI’s business to monitor. Regulators have already pioneered network modelling to identify the core banks and to rank their systemic importance, and can now demand much higher standards of risk management from the SIFIs. Increasingly, similar models are being used by risk practitioners and investment managers.

The studies of network theory in financial risk management, such as those carried out by the Centre of Risk Studies, provide valuable insight for all risk practitioners involved in managing financial risk by providing a robust foundation of science from which to understand, model and, ultimately, manage financial risk effectively.

Senior Vice President, RMS

Dr. Andrew Coburn currently leads the cyber risk research at RMS, developing cyber risk scenarios and analytics. In his 20 year career at RMS, he has managed the innovation of many new risk models, ranging from natural catastrophes, to terrorism, pandemics, longevity, and most recently, cyber risk. Dr. Coburn is recognized as an authority on catastrophe risk modeling.

Andrew is also a founder and member of the executive team of the Centre for Risk Studies, University of Cambridge, where he directs research into the risk of catastrophic collapse of complex systems. He leads a research team that coordinates a program of cyber risk research, whose work has included the development of the cyber insurance exposure data schema, the production of the Lloyd’s Business Blackout scenario of a cyber attack on U.S. power grid now used as a Lloyd’s RDS, and research that underpinned the decision by Pool Re to extend their cover to cyber terrorism.

Andrew is the author of "Earthquake Protection", co-authored with R.J.S. Spence, John Wiley & Sons, first edition 1998, second edition 2002. He is also the co-author of a forthcoming book "Solving Cyber Risk", to be published by Wiley in 2019.

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