Lecture 7: Stochastic Financial Networks

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ROBERT M. TOWNSEND: So let me just say from the beginning, there are some connections between the lecture today and the one last time, and I will try to point that out.

And then there's a missing third lecture. If time permits, I will kind of outline that at the end of today, but let's see how it goes with these slides first.

So this is stochastic financial networks, liquidity and the value of key players versus contagion dynamics.

Or to put it succinctly, do we enhance or limit markets? So here's an outline. Introduction to stochastic financial networks, showing you how markets vary over time and in principle with other shocks.

I'll lay out the economic environment. We'll define a stochastic financial network with examples. Anyone who participates at all is in a centralized market and otherwise isolated, and in the second, the markets fragment.

They're partitioned. And then we'll think about ex-ante injections of liquidities as buffers against shocks, and in particular try to pinpoint who would be the most valued person to receive the injection of liquidity to carry it into subsequent markets in which that agent participates.

And so we'll characterize the most valued player in that sense, in the baseline environment, and also for a more general class of environments.

And then we'll do some positive economics. What does this value correspond with in financial markets, go to Thai villages you've seen before and do some empirical work to see how well the theory is holding up, at least at an initial level, and end with financial centrality and contagion, disease, systemic risk.

And the point is to compare and contrast the market making aspect of judiciously chosen liquidity injections with what is the current policy framework, which is to limit the interactions across players due to this concern about financial contagion.

All right. So I should say from the outset that when these slides were written and the draft of the paper, we were referring to our measure of the value of liquidity for key players as a measure of financial centrality.

That has caused confusion because people associate financial centrality and network financial centrality with the contagion point of view.