Looking Deeper, Seeing More: A Multilayer Map Of The Financial System by Richard Bookstaber and Dror Y. Kenett – OFR with a “shout out to hedge funds”
This brief introduces a multilayer map to show how risks can emerge and spread across the U.S. financial system. The three layers in the map represent short-term funding, assets, and collateral flows. Risk is transformed and moves from one layer of the map to the next through transactions among large market players. This brief uses the difficulties faced by Bear Stearns and its two failed hedge funds during the financial crisis as a case study to illustrate how the multilayer map can shed light on potential vulnerabilities and paths of contagion. The map requires detailed data to illustrate the full scope of interconnections in the financial system.
The 2007-09 financial crisis showed the need for a more sophisticated way to monitor the financial system. Risks emerged and spread in unanticipated ways. The Financial Crisis Inquiry Commission noted that a “tangle of interconnections” played an important role in the spread and magnitude of the crisis. Today, focusing on risks from a single type of financial institution or product is no longer adequate. Regulators need information about the many exposures that market participants have to each other.
This brief presents the financial system as a multilayer map, building on earlier OFR papers that analyzed single layers. The three layers in the map show flows of short-term funding, assets, and collateral. The layers are linked by large banks, hedge funds, central counterparties (CCPs), and other market participants.
The multilayer map reveals potential channels of contagion that are not visible in single-layer maps. A risk to an activity in one layer can become a risk to activities in other layers. For example, a large bank or dealer facing a shortfall in funding might reduce its lending to several hedge funds (funding layer), and the hedge funds might respond by liquidating assets (asset layer), resulting in a drop in asset prices that affects collateral values (collateral layer).
The multilayer map provides a new way to analyze the role of financial institutions as potential sources of stability or instability. It also identifies the types of data that could be useful for a fuller analysis of threats and vulnerabilities. Policymakers could use the map to monitor the stability of the financial system as a whole.
The multilayer map is more than conceptual. The case study in this brief shows that the map can illustrate how the 2007 collapse of two Bear Stearns hedge funds that had invested mostly in mortgage-linked securities and the subsequent troubles of Bear Stearns itself affected the entire financial system.
The Financial System: A Network of Networks
As in earlier OFR papers, this brief analyzes the financial system as a network. Network analysis is a relatively new tool for studying the financial system. Epidemiologists have long used network analysis to track and contain the spread of contagious diseases. More recently, intelligence experts have used it to analyze terror networks.
Network analysis looks at relationships in key areas of the financial system instead of focusing primarily on the balance sheet of a single company. It can be used to study the resilience of individual counterparties and their impact on the broader system.
The financial network map in Figure 1 shows the relationships among market participants. It highlights the central role played by a typical large bank or dealer.
These types of companies are labeled in the map as “Bank/Dealers.” Each node in the map represents a market participant. Banks, CCPs, hedge funds, pension funds, insurance companies, exchanges, and institutional customers are nodes. A link between two nodes represents a relationship, such as a loan, derivative, or other type of financial contract or obligation.
Most network research has analyzed the financial system as a single-layer network within one market or involving one type of transaction. However, transactions differ among companies and within them. Also, money or collateral do not simply flow from one entity to another. Market participants transform short-term funding, assets, and collateral as cash, and securities flow throughout the financial network. One layer cannot adequately represent all of these transformations.
Multilayer maps can capture more information. They portray the financial system as a network of networks. For example, a multilayer map can help identify a large market participant that is a node in more than one market layer. Such a company could be a source of strength to the financial system, if managed well. If not, it could be a source of weakness. The failure of one of these nodes in a layer can lead to failures of dependent nodes in other layers. This phenomenon can happen repeatedly, leading to a cascade of failures. For that reason, multilayer networks are more fragile than single-layer networks. Connections between the layers can amplify the scope and magnitude of stress in a single layer.
Maps of multilayer networks show three stages of damage following a major shock. The initial stage is a fast, sharp decline in network nodes. Next is a lengthy plateau period when damage spreads slowly through the network. The final stage is a rapid, cascading collapse of remaining network nodes.
Mapping the Three Layers
This section describes independent network maps for three key financial activities: funding, assets, and collateral. The three maps are shown in Figures 2, 3, and 4. Each map replicates Figure 1, but with key market participants or bank/dealer desks displayed in dark colors to highlight their roles in each layer.
To illustrate each layer map, the analysis focuses on Bear Stearns and two large hedge funds run by its asset management unit, the High-Grade Structured Credit Strategies Fund (High-Grade Fund) and the High-Grade Structured Credit Strategies Enhanced Leverage Fund (Enhanced Leverage Fund). The High-Grade Fund was launched in 2003 and quickly attracted more than $1 billion of investor capital. The Enhanced Leverage Fund was launched in 2006 with nearly $800 million from investors.
Bear Stearns is a good example because it was involved in all three layers. The failure of the two hedge funds in 2007 and the subsequent forced sale of Bear Stearns itself less than a year later were important events in the financial crisis, as discussed later in this brief.
The funding map shows how funding moved through a large bank or dealer such as Bear Stearns before the crisis (see Figure 2). At the center is the bank/dealer’s financing desk, where the bank/dealer accesses overnight or short-term funding, including secured funding through repurchase (repo) agreements. On the right side of the map, asset managers, depositors, and others provide cash to the bank/dealer.
The bank/dealer’s prime broker, shown in orange in the center at the top of the map, provides short-term funding to hedge funds and other customers. The bank/dealer’s corporate treasury, shown in grey at the bottom, issues equity and debt, including commercial paper.
Before the crisis, Bear Stearns depended heavily on short-term funding, largely commercial paper and repo funding provided by asset managers and other cash providers (shaded blue on the right side of the map). Its leverage, measured by total assets relative to equity, was nearly 40-to-1 — high for a commercial bank but typical for an independent investment bank before the