Paper: arXiv 2411.10386

Authors: Kamil Fortuna, Janusz Szwabiński

Abstract

The fragility of financial systems was starkly demonstrated in early 2023 through a cascade of major bank failures in the United States, including the second, third, and fourth largest collapses in the US history. The highly interdependent financial networks and the associated high systemic risk have been deemed the cause of the crashes. The goal of this paper is to enhance existing systemic risk analysis frameworks by incorporating essential debt valuation factors. Our results demonstrate that these additional elements substantially influence the outcomes of risk assessment. Notably, by modeling the dynamic relationship between interest rates and banks’ credibility, our framework can detect potential cascading failures that standard approaches might miss. The proposed risk assessment methodology can help regulatory bodies prevent future failures, while also allowing companies to more accurately predict turmoil periods and strengthen their survivability during such events.

Complexity vs Empirical Score

  • Math Complexity: 6.5/10
  • Empirical Rigor: 6.0/10
  • Quadrant: Holy Grail — high math complexity, high empirical rigor

Why this score: The paper provides a valuable extension to systemic risk modeling by embedding reduced-form credit risk formulas (Duffie-Singleton) directly into the NEVA balance sheet network framework. The theoretical synthesis is mathematically sound and addresses a key limitation in standard DebtRank models, though empirical testing is primarily illustrative via stress-testing frameworks.

Research Flowchart

  flowchart TD
    A[Research Goal: Enhance systemic risk framework using debt valuation factors] --> B[Input Data: Financial network interdependencies & market interest rates]
    B --> C[Methodology: Model dynamic relationship between interest rates & bank credibility]
    C --> D[Computational Simulation: Execute multi-asset cascading failure analysis]
    D --> E[Outcome: Detect hidden cascading risks missed by standard models]
    E --> F[Application: Enable regulatory prevention & improve firm survivability]