Monthly Archives: December 2017

Prof Nizar Allouch

Strategic default in financial networks

by Nizar Allouch, University of Kent and Maya Jalloul, Queen Mary, University of London. Discussion paper KDPE 1721, December 2017.

Non-technical summary:

Financial institutions carry out various transactions with each other, including risk-sharing and insurance. The architecture of the network of transactions between institutions can support financial stability because it enables them to share funding or transfer risk. But these linkages can also facilitate the diffusion of shocks through the system, due to chains of default and the domino effect. This is referred to as systemic risk. Systemic risk is costly for individuals, institutions and economies, as demonstrated by the last financial crisis (of 2008). The obvious need for a stable financial system has led to a significant interest in policies that could reduce systemic risk and mitigate contagion.

This paper investigates a model of strategic interactions in financial networks, where the decision by one agent on whether or not to default impacts the incentives of other agents to escape default. Agents’ payoffs are determined by the clearing mechanism introduced in the seminal contribution of Eisenberg and Noe (2001). We first show the existence of a Nash equilibrium of this default game. Next, we develop an algorithm to find all Nash equilibria that relies on the financial network structure. From a policy perspective, given that inefficient coordination on a bad Nash equilibrium might pose a severe economic problem, there is a need for financial institutions fostering efficient coordination of agents’ decisions. Recently, central clearing has become the cornerstone of policy reform in financial markets since it limits the scope of default contagion. Our analysis shows that introducing a central clearing counterparty (CCP) also allows agents to coordinate on the efficient equilibrium at no additional cost. As a consequence, our result reinforces the key role central clearing counterparty (CCP) plays in stabilising financial markets.

You can download the complete paper here.

Dr Adelina Gschwandtner

Improving drinking water quality in South Korea: A choice experiment

by Adelina Gschwandtner, University of Kent; Cheul Jang, Korea Water; and Richard McManus, Canterbury Christ Church University. Discussion paper KDPE 1720, December 2017.

Non-technical summary:

South Korea is a country with a historically polluted water supply. Water pollution has spread according to economic development worldwide. Increased discharges of untreated sewage combined with agricultural runoff and inadequately treated wastewater from industry, have resulted in the severe degradation of water quality all over the world; however, the situation appears to be especially worrying in South Korea. Several accidents of contamination in the water such as detection of trihalomethanes, heavy metal, harmful pesticides and disease germs in tap water, have made the average Korean concerned about the safety of the water supply, and very few citizens drink water directly from the tap.

It is reported that only 3.2% of the population in South Korea drink untreated tap water. Most Koreans use in-line filters and the annual sales of bottled water has increased exponentially in recent years. The present study aims to understand the main causes of pollution in a specific target area in South Korea and to investigate the feasibility of installing two different advanced water treatment systems in order to improve the water quality in the waterworks. The study shows that the main cause for pollution is agriculture, more specifically livestock sewage, and that in the long-run the reduction of pollution from livestock and the protection of the quality of the water in the river basin should constitute the main priority of policy measures.

In the short-run, installing either of two advanced water treatment systems is shown to be a feasible solution under conservative assumptions. The minimum monthly increase in water bill accepted by the Korean citizens is $2 which aggregates to a minimum net present value of $11 million over a project life of 20 years. Increasing the social discount factor from 4.5% to 10%, decreasing the useful life of the project below 12 years, and significantly cutting the estimated benefits can make the alternative investments unfeasible; however, these situations are unlikely to occur. The results remain robust to various other sensitivity analyses and therefore, the study shows that in general the instalment of the two advanced water treatment systems is beneficial to the South Korean citizens and constitutes a viable solution for the pollution of potable water in the short-run.

You can download the complete paper here.

Dr Alfred Duncan

Financial frictions in macroeconomic models

by Alfred Duncan, University of Kent and Charles Nolan, University of Glasgow, discussion paper KDPE 1719, December 2017.

Non-technical summary:

In recent decades, macroeconomic researchers have looked to incorporate financial intermediaries explicitly in business cycle models. These modelling developments have helped us to understand the role of the financial sector in the transmission of policy and external shocks into macroeconomic dynamics. They have also helped us to better understand the consequences of financial instability for the macroeconomy.

There remain large gaps in our knowledge of the interactions between the financial sector and macroeconomic outcomes. Specifically, the effects of financial stability and macroprudential policies are not well understood.

You can download the complete paper here.

Prof Nizar Allouch

Aggregation in networks

by Nizar Allouch, discussion paper KDPE 1718, December 2017.

Non-technical summary:

Understanding, and making sense of, large economic networks is an increasingly important problem from an economic perspective, due to the ever-widening gap between technological advances in constructing such networks, and our ability to predict and estimate their properties. Throughout history, various concepts have been developed to reduce the inherent complexity found in large economic systems, thereby rendering them more amenable to economic analysis. One prominent example is aggregation, which aims to devise representative concepts that can be analyzed in a more tractable manner. For instance, a key question, which appeared in the seminal contributions of von Neumann and Morgenstern (1944), Chapter IX, Gorman (1953, 1961), and Shapley (1964, 1967), is: when does a group of individuals behave as if it were a single individual?

Our investigation of aggregation in network games is quite similar in motivation. Often, the reason such an argument holds in the above literature appears to hinge on having identical preferences or compositions. Our approach suggests that aggregation holds for a similar reason in network games; however, the homogeneity is brought about by the network architecture rather than behavior or structure.

Our findings could potentially have empirical applications to many network models in economics, including public goods and targeting/finding the key players policies. Nonetheless, it remains to be seen whether other approaches from the vast and important literature on network position similarity, across myriad disciplines, ranging from biology and sociology to computer science – see, for example, Gagneur et al. (2004) and Newman (2006) – could be useful to further analyze complex strategic interactions.

You can download the complete paper here.