Contagion amongst Banks
This week’s PBS Frontline show was fascinating. They discussed the financial meltdown and how it was exacerbated by the massive intra-connectivity of the banking system.
Frontline focused on the trade-offs between “moral hazard” — punishing the bad guys for bad behavior, and “systemic risk” — allowing the bad guys to fail and effect the rest of the interconnected system. The main contagion under discussion were the investments created by Bear Stearns, Lehman Brothers — packaging up sub-prime and other mortgages into mortgage-backed securities which were then sold to other banks and investors.
Using social network analysis, let’s take a look at how a contagion spreads through a connected system. Below, is a small-world network that models what the interconnected banking ecosystem may look like. The red nodes represent banks, while the grey links represent who may be doing business with whom. The arrows represent the flow of assets [who pays whom].