Keshav passed along some links to papers on financial networks that are being presented at the EEA conference that he is attending. I have glanced over the abstracts from the papers that and they all remind/reinforce what I think is the major insight from the networks literature on systemic risk in the financial sector that was extremely under appreciated until very recently:

Individuals agents in the financial sector who are rationally pursuing strategies that minimize their individual idiosyncratic financial risks can actually cause substantial increases in overall/systemic risk in the financial sector. If individual agents and their risk mitigation strategies existed independently of one another (i.e., did not interact) then minimizing their risks individually would surely (I think) lead to a minimization of systemic risk as well. The key issue that the network literature focuses nicely on is that financial agents and their strategies do interact with one another and that these interactions can create both stabilizing and destabilizing (depending on circumstances) feedback effects. Oftentimes the destabilizing feedback effects dominate...

Generally speaking I think most policy makers would have assumed that a regulatory/incentive structure in the financial system that encouraged all players to mitigate individual risk would also be a good regulatory framework for mitigating systemic risk. Based on recent empirical evidence and research I would say that this notion should be discredited...Given that there seems to be a trade-off between mitigating individual and systemic risk, the hard part from a policy perspective is how do you a design a regulatory regime that encourages mitigation of some weighted average of individual vs. collective/systemic financial risk.

Different papers in the financial networks literature look at a variety of specific issues that relate to systemic risk, but ultimately it is the trade-off between mitigating individual risk and mitigating systemic risk that continues to emerge. Maybe I am wrong about my interpretation of the literature...but for me at least, this has been my major takeaway...

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## Wednesday, August 25, 2010

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