Process Systems Engineering as a Modeling Paradigm for Analyzing Systemic Risk in Financial Networks

Abstract

The recent financial crisis and the ensuing sovereign debt crisis once again highlighted that understanding the potential instabilities in the financial system is of great societal value. Financial instability typically results from positive feedback loops intrinsic to the operation of the financial system. The challenging task of identifying, modeling, and analyzing the causes and effects of such feedback loops requires a proper systems engineering perspective that is lacking in the remedies proposed in recent literature. We propose that signed directed graphs (SDG), a modeling methodology extensively used in process systems engineering, is an appropriate framework to address this challenge. The SDG framework is able to represent and reveal information missed by more traditional network models of financial system. This framework adds crucial information to the edges in a network in terms of the direction of flows and relationship between the variables associated with the nodes at the two ends of a directed edge, thereby providing a framework for systematically analyzing the potential hazards and instabilities in the system. This article also discusses how the SDG framework can facilitate the automation of the identification and monitoring of potential vulnerabilities. These are illustrated with an example of a bank-dealer case study.

TOPICS: Financial crises and financial market history, quantitative methods