The Price of Complexity in Financial Networks

Abstract

Financial institutions form multi-layer networks of contracts among each other and exposures to common assets. As a result, the default probability of one institution depends on the default probability of all the other institutions in the network. Here, we show how small errors on the knowledge of the network of contracts can lead to large errors on the probability of systemic defaults. From the point of view of financial regulators, our findings show that the complexity of financial instruments and the complexity of networks of contracts may decrease our ability to estimate and mitigate systemic risk.