Toward EffEctivE GovErnancE of Financial insTiTuTions

In what follows, we construct a simple nancial system involving entities with interlocking balance sheets and use these techniques to model the spread and probability of contagious default following an unexpected shock, analytically and numerically. Unlike the generic, undirected graph model of Watts (2002), our model provides an explicit characterisation of balance sheets, making clear the direction of claims and obligations linking nancial institutions. It also includes asset price interactions with balance sheets, allowing the effects of asset-side contagion to be clearly delineated. We illustrate the robust-yet-fragile tendency of nancial systems and analyse how contagion risk changes with capital buffers, the degree of connectivity, and the liquidity of the...