Systemic Risk and Financial Networks

The Focus Period on Systemic Risk and Financial Networks.

Financial markets are not physical systems. The rules they operate are determined by regulation, and the operators try their best to influence and circumvent these regulations insofar as they thwart their own ends. Asset prices are modelled by stochastic processes, as if the randomness came from an outside source, but the markets themselves generate much of the noise. Risk is the downside of randomness. The proposed program will focus on the way the markets generate and propagate risk, and what kind of regulation can mitigate it. 

The major source of risk in the market is moral hazard, the incitment for an operator (the agent), acting on behalf of someone else (the principal), to take more risk than his/her customer would want, on the assumption that if the bet goes the wrong way, the principal (and not the agent) will bear the cost. This problem is inbuilt in the financial system (limited liability), and the 2008 financial crisis has brought it in the limelight. Such problems used to be mathematically intractable, but a recent breakthrough by Sannikov (relying on the martingale representation theorem) has opened up the field to analysis. More generally, one is moving quickly towards a general theory of principal-agent problems in continuous time, and the PIMS focus period would give it an important boost.

The other source of risk is the network. Markets around the world are now interconnected (although they are not open at the same hours, which creates strategic opportunities), and trades are now down to the millisecond. There is no clear understanding of how such a network functions and how robust it is. Two things are sure: (a) it can fail globally, for no apparent reason (cf. the flash crash of May 6, 2010) (b) failure at one node (for instance, one party to a trade fails to deliver) can propagate and bring down the whole network. These problems have been investigated, from an empirical point of view, by Joseph Stiglitz and his school. From the mathematical point of view, there have been studies of large networks by Papanicolaou, and it is expected that they will bring some understanding to financial networks.From the economic and financial point of view, it should not be necessary to point out the importance of studying global systemic risk in the financial network. Failure of this network has consequences which can only be characterized as catastrophical. Understanding how it functions is crucial, not the operators, but for the regulators and the public at large, in order to establish rules that will minimize the source and the impact of failures. 

This Focus Period is organized by:

* Alejandro Adem (UBC) 

* Rene Carmona (Princeton University)

* Ivar Ekeland (University Paris Dauphine)

* George Papanicolaou (Stanford University) 


Activities include: 

Summer School: A Summer school on  the Economics and Mathematics of systemic Risk is planned for July 21- 25, 2014.

Workshop: The Economics and Mathematics of Systemic Risk Workshop is scheduled for July 28- 30, 2014 

Visitors: A number of senior visitors will be in residence at PIMS during July 2014, including Ivar Ekeland and Jean Charles Rochet. There will be seminars and other activities during that month.