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Systemic Risk and Feedback to the Real Economy

Final Report Summary - SYSTEMICRISK (Systemic Risk and Feedback to the Real Economy)

This ERC grant allows pursuing research on two themes. The first is on network and systemic risk, which focuses on measuring interactions among economic agents that aggregate into systemic risks using networks. The second is on feedback effects and endogenous systemic risk, which is to model frictions and reasons for coordinated actions of economic agents in the financial market and sources of systemic risks. Under the first theme, we have completed a project that estimate systemic liquidity risk in the UK interbank bank over the boom, crisis, and QE periods guided by a network model of liquidity provision among names. The project is the first to estimate the liquidity multiplier in the interbank market and has shown it is time varying. It contributes significantly to the understanding of inside and outside money creation in the macroeconomics literature – showing the interbank network’s capacity to generate liquidity crucially depends on coordinated behaviour of banks. It also contributes to the finance literature by proposing a network impulse response function and using it to estimate the systemic risk. This project is generating impact on both academic and policy realms. I presented it widely to central bankers, financial regulators, academic audience, top finance academic conferences. I have also completed a paper with Vicente Cunat and Dragana Cvijanovic on “Within-Bank Transmission of Real Estate Shocks” is under several revisions and currently under review at a finance field journal. It estimates the broad impact of geographic connection of banking operation in transmitting adverse real estate shocks during the Great Depression. Its estimates show how banks, upon receiving adverse real estate shocks in difference geographic locations, deal with deleveraging decisions. Finally, I have completed the paper with Christian Julliard, Zijun Liu, Seyed Esmaeil Seyedan on “The UK Repo Market and the Haircut.” This is one of the first papers to study repo haircut determinants using a comprehensive database on repo haircut determinants. Its finding will help understand the collateral network in the UK banking system. I have presented the findings to the Bank of England and the paper is currently under review at a top journal.

Under the second theme, we have built an influential model that studies the feedback effect from the financial market to the real economy using the information channel. The outcome of this project is already published in the leading academic journal. It has been applied to explain the Great Recession where the volatility in the financial market causes the changes in the real economy. This one is with Emre Ozdenoren, a co-PI of the grant. It shows that the systemic risk arises endogenously from contractual and information frictions, highlighting the role of a central planner in moderating the impact of these frictions. I have also completed an innovative methodological paper with Georgy Chabakauri and Konstantinos Zachariadis . It is on “Multi-Asset Noisy Rational Expectations Equilibrium with Contingent Claims,” under review at a top economic journal. It develops a new framework in modeling asset price formation in the presence of information frictions where assets can be any types of derivatives. It formulates an information spanning condition that results in a M-M equivalent result of information irrelevant theorem.