Propagation of Bankruptcy Risk over Scale-Free Economic Networks

Abstract

The propagation of bankruptcy-induced shocks across domestic and global economies is sometimes very dramatic; this phenomenon can be modelled as a dynamical process in economic networks. Economic networks are usually scale-free, and scale-free networks are known to be vulnerable with respect to targeted attacks, i.e., attacks directed towards the biggest nodes of the network. Here we address the following question: to what extent does the scale-free nature of economic networks and the vulnerability of the biggest nodes affect the propagation of economic shocks? We model the dynamics of bankruptcies as the propagation of financial contagion across the banking sector over a scale-free network of banks, and perform Monte-Carlo simulations based on synthetic networks. In addition, we analyze the public data regarding the bankruptcy of US banks from the Federal Deposit Insurance Corporation. The dynamics of the shock propagation is characterized in terms of the Bank Failures Diffusion Index, i.e., the average number of new bankruptcies triggered by the bankruptcy of a single bank, and in terms of the Shannon entropy of the whole network. The simulation results are in-line with the empirical findings, and indicate the important role of the biggest banks in the dynamics of economic shocks.

Keywords

• financial contagion
• bankruptcy risk
• scale-free networks
• targeted attacks
• Shannon entropy