Map Gives Clearer Picture of Pathways That Affect Financial Stability

Scientists have long used network analysis to track and contain the spread of disease. A new OFR brief applies a similar approach to identify potential paths of contagion in the U.S. financial system.

Authors Richard Bookstaber and Dror Y. Kenett have created a network map with three layers. Each layer represents a key function of the financial system. Flows of short-term funding, collateral, and assets are each depicted in a layer. The three layers are linked by large banks, hedge funds, central counterparties, and other market participants that contribute to two or more types of financial flows.

The multilayer map reveals new potential channels of contagion that are not visible in a single-layer map. As an example, the authors use the map to show impacts from the 2007 collapse of two Bear Stearns hedge funds and the later problems of the parent company.

Bear Stearns is a good example because it was involved in all three layers of the map. Its problems began in the asset layer when the value of a benchmark index of securities held by its hedge funds began falling. Investors in the two hedge funds withdrew money (in the funding layer). Lenders to the funds marked down the value of their assets and demanded more collateral (the collateral layer). Both funds were forced to sell assets at distressed prices to raise cash and eventually collapsed. In the months that followed in 2008, the parent company lost the confidence of its counterparties and was sold to avoid bankruptcy.

The brief builds on two earlier OFR papers that focused on the funding map and the collateral map individually.

The multilayer map is a promising new tool, but to be operational, it requires data. For example, today we have detailed information about the exposures and holdings of Bear Stearns and its hedge funds before the crisis. Those data make possible the case study in the brief. Comparable data on current exposures and holdings of market participants would enable use of the multilayer map to study today’s potential contagion scenarios in greater depth.

Stacey Schreft is Deputy Director for Research and Analysis at the Office of Financial Research