Definition of network risk: Ch. 7

[Merlinius]

In chapter 7 of book 1, network risk is defined. However, I do not understand it or the example that is given.



This comes directly from Brunnermeier (2009) since it is identical to the book.

In the given example Goldman has a swap agreement with the hedge fund which in turn has a swap agreement with Bear Stearns. Then somehow it is relevant that it would be unwise for Goldman to renew the contract with Bear Stearns. I find this confusing because Goldman does not have a contract with Bear Stearns in the example (only with the hedge fund).

The chapter continues but this section reads as if "network risk" should be illustrated within these sentences. Also in the BT study notes the same (paraphrased) section ends with "This best explains the networking risk". However, I fail to see the definition of "network risk" within the example.

Can somebody help?

 

[David Harper CFA FRM]

Hi @Merlinius That's a good point, in my opinion. First, I can speak to what Brunnermeier means (if only because it is thematic in P2.T6 Credit Risk). True, Goldman has entered into (and will decide whether to renew) a derivatives contract with counterparty, say, Acme Hedge Fund. Not only the decision to renew, but the pricing as well (via CVA), depends on Goldman's evaluation of the credit risk of Acme. When the credit risk concerns a derivatives counterparty it is called counterparty risk (or counterparty credit risk), which to me is just to signify that it's a particular flavor of credit risk, that is credit risk in a bilateral contract (as opposed to funded loan's credit risk).

It's true as you say that Goldman does not, in this illustration, have a contract directly with Bear. However, Goldman's criteria, if not the primary criteria, is the evaluation of Acme's credit risk as Goldman's counterparty. (And I remind you: even if Goldman is "confident" that Acme will fulfill obligations, it will evaluate the credit risk in the specific for purposes of pricing. If it's important, there will be a total body scan, so to speak). Naturally, part of the evaluation includes Acme's own assets and obligation: just as the balance sheet liabilities must be evaluated, so too must off-balance-sheet derivative obligations and assets. Goldman would look at the "off balance sheet" contract that Acme has with Bear Stearns. If it deems Bear will default, then that could impact Acme. How? If Acme's IRS is "in the money" (i.e., has positive credit exposure), then Acme is owed money but waits to get repaid. Not totally unlike a corporation with accounts receivable. In this way, an evaluation of Bear (as Acme's counterparty) would be actually part of a detailed look at Acme's economic balance sheet, and the situation with Bear could be analogous to a determination that Acme is exposed to Accounts Receivables that won't be collected. Although, I will add that I'm not totally confident Brunnermeier's example captures the full dynamics at the time: my mere recollection is that Goldman also had (maybe) more direct role with Bear (as a backstop or LOC or something like that) and they pulled the rug out from Bear Sterns by going public with their lack of confidence. It's a confidence game, and what really got them was the mere announcement/message by Goldman in the lack of confidence, in my recollection.

Second, with respect to "network risk," I do not think the phrase is well-defined in the FRM syllabus (is why I think you are making a helpful point). To the extent my interpretation is valid, I think "network risk" is used here in a way that is similar to, or might be associated with the following:

• Too interconnected to fail
• Chain reaction (among derivative counterparties), or even
• A certain type of (sub-class of) contagion

In this way, it would be a sub-class of systemic risk (not to be confused with systematic risk which is the β in CAPM). Actually, I think "network risk" is as good, or better, as any of the other terms used in P2.T6 or P2.T9. I hope that's helpful!

 

[Merlinius]

Thank you very much for your detailed response, this makes a lot of sense to me!