Santa Fe Institute

Systemic risk tax could diminish cascading failures in interbank lending

April 13, 2016 1:17 p.m.

Lending and borrowing among banks occurs in a networked system in which the risk is a concern not only for the two parties involved, but for everyone in the system—including the public if failures of portions of the system result in government-funded bailouts. Managing systemic risk in such interbank financial networks thus means reducing not just the risk to lending and borrowing institutions, but also limiting the possibility of cascading failures through the system.

In a paper just published in Quantitative Finance, SFI External Professor Stefan Thurner and colleagues explore ways to minimize the systemic risk in financial networks. They suggest that a tax on individual loans between financial institutions—based on the marginal systemic risk each transaction adds to the system—could essentially eliminate the risk of future collapses of the financial system.

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Image caption: (a) Austrian interbank network 2006, (b) 20 largest banks, (c) without a tax, (d) with the Financial Transaction Tax, and (e) with the Systemic Risk Task. Nodes (banks) are red for systemically important banks to green for systemically unimportant banks.

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Their study relies on a network analysis of multilayer banking systems in Austria and Mexico to quantify the share of systemic risk individual liabilities contribute to overall systemic risk. Their analysis shows that the marginal contribution of individual liabilities to overall systemic risk varies by a factor of a thousand. A leveed risk-proportional tax could go into a government fund that might be used to bail out a struggling bank, they say.

“There’s currently a lot of discussion about a Tobin tax in the European Union, but the version they are proposing would tax every transaction at the same level," he says. "The tax we are proposing would act as an incentive scheme for avoiding transactions that would be the most harmful for the system, as banks would try to avoid transactions that generate that risk."

Read the paper in Quantitative Finance (April 11, 2016)

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