Unveiling Early Warning Signals of Systemic Risks in Banks: A Recurrence Network-Based Approach

Paper: arXiv 2310.10283

Authors: Shijia Song, Handong Li

Abstract

Bank crisis is challenging to define but can be manifested through bank contagion. This study presents a comprehensive framework grounded in nonlinear time series analysis to identify potential early warning signals (EWS) for impending phase transitions in bank systems, with the goal of anticipating severe bank crisis. In contrast to traditional analyses of exposure networks using low-frequency data, we argue that studying the dynamic relationships among bank stocks using high-frequency data offers a more insightful perspective on changes in the banking system. We construct multiple recurrence networks (MRNs) based on multidimensional returns of listed banks’ stocks in China, aiming to monitor the nonlinear dynamics of the system through the corresponding indicators and topological structures. Empirical findings indicate that key indicators of MRNs, specifically the average mutual information, provide valuable insights into periods of extreme volatility of bank system. This paper contributes to the ongoing discourse on early warning signals for bank instability, highlighting the applicability of predicting systemic risks in the context of banking networks.

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 presents an innovative application of nonlinear dynamics and multiplex recurrence networks (MRNs) to high-frequency Chinese banking stock returns for systemic risk monitoring. While novel in applying topological network indicators like average mutual information as early warning signals, the empirical validation would benefit from broader out-of-sample testing across multiple financial crises.

Research Flowchart

  flowchart TD
    A[Goal: Identify Early Warning Signals for Systemic Bank Risks] --> B[Input: High-Frequency Stock Returns of Chinese Listed Banks]
    B --> C[Method: Multidimensional Nonlinear Time Series Analysis]
    C --> D[Process: Construct Multiple Recurrence Networks]
    D --> E[Compute MRN Indicators & Topological Structures]
    E --> F[Outcome: Average Mutual Information Predicts Extreme Volatility]