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Introduction Network Insights Surveillance Open issues
Measuring systemic risk in financial networks:Progress and challenges
Stefano Battiston
University of Zurich
Workshop on Systemic risk and regulatory market risk measuresParmenides Found. Pullach, 2 June 2014
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Acknowledgments
Swiss National Fund, Inst. of Banking and Finance, UZH
SNF Professorship at IBF, UZH - Financial Networks andSystemic risk
EU-FET SIMPOL 2013-2016 www.simpolproject.eu
Financial Systems Simulations and Policy Modeling
Networks of complex fin. instruments and shadow,climate-finance and networks of influence on regulation process
EU-FET FOC 2010-2014 www.focproject.eu
Forecasting Financial Crises
Network tools for financial regulation
INET - Financial Stability Program (dir. by Stiglitz)
WG on Financial Networks - (chair Haldane)Political economy aspects of fin. stability
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Overview
Problem: risk measures (VAR and ES) neglect systemdimension
Insights from network approach for
policies for financial stabilitysurveillance
The future:
Open issues and future research
Battiston and Caldarelli 2013, Systemic Risk in Financial Networks, JMFI
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Progress on Systemic Risk Measures
It is possible to:
quantitatively measure systemic impact conditional to shocks[DebtRank, Battiston ea. 2012]beyond default-only, beyond interbank-only
Policy insights
Connectedness / Risk diversificationOptimal structure of the banking systemIndicators for SIFI and systemic impactHow do we contain systemic risk?International nexus of TBTF institutionsSurveillance
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Issues on Systemic Risk Measures
open questions
estimate the probability of shocks in the futurestructural breaks
VAR and ES are likely to be heavily underestimated
VAR and ES do not account interdependence. No analyticalsolution. Numerical work.VAR of a bank in isolation differs from VAR of a bank in anetworksystemic VAR of a network of interconnected banks from VARof aggregated system
Risk measures are blind1 to asset overvaluation2 network effects3 procyclical effects
risk: the whole exercise might give new but false sense ofsecurity
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
The Financial System as a Network
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
The Financial System as a Network
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
The Financial System as a Network
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
The Financial System as a Network
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
The Financial System as a Network
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Financial Networks: Levels of Analysis
1 Static level, descriptive topology, across countries and legalsettings
2 Simplified agent behaviour: response to shocks and resilience.3 Strategic interaction: endogenous link formation, efficiency vs
stability, welfare issues4 Political economy: endogenous influence over rules of the
game: Meta-game and power
RemarksResilience analysis in absence of amplifications (level 2-3)can be misleading.
Results on connectedness tend to be opposite
Welfare analysis at level 3 maybe misleading. Level 4required.
Are the welfare measures appropriate and encompassing effectsto real economy?Is market power and regulatory capture taken into account?
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Financial Networks: Levels of Analysis
1 Static level, descriptive topology, across countries and legalsettings
2 Simplified agent behaviour: response to shocks and resilience.3 Strategic interaction: endogenous link formation, efficiency vs
stability, welfare issues4 Political economy: endogenous influence over rules of the
game: Meta-game and power
RemarksResilience analysis in absence of amplifications (level 2-3)can be misleading.
Results on connectedness tend to be opposite
Welfare analysis at level 3 maybe misleading. Level 4required.
Are the welfare measures appropriate and encompassing effectsto real economy?Is market power and regulatory capture taken into account?
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Financial Networks: Levels of Analysis
1 Static level, descriptive topology, across countries and legalsettings
2 Simplified agent behaviour: response to shocks and resilience.3 Strategic interaction: endogenous link formation, efficiency vs
stability, welfare issues4 Political economy: endogenous influence over rules of the
game: Meta-game and power
RemarksResilience analysis in absence of amplifications (level 2-3)can be misleading.
Results on connectedness tend to be opposite
Welfare analysis at level 3 maybe misleading. Level 4required.
Are the welfare measures appropriate and encompassing effectsto real economy?Is market power and regulatory capture taken into account?
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Insight 1: Network density. In the literature
Policy discourse
Before the crisis: linkages and diversificationWidely-held view diversification is always good.
After the crisis: linkages and contagion
Optimal diversification is interior:
Various mechanisms: amplifications, bank runs, fire-sales,systemic risk costs: Brock et al. (2009); Ibragimov et al.(2011); Ibragimov and Walden (2007); Stiglitz (2010);Wagner (2009). Battiston ea. 2012 Liaisons; Tasca andBattiston 2012; 2013; Battiston ea. 2012 Default; Roukny ea.2013.
Optimal diversification is maximal:
Portofolio context: Markowitz (1952), Tobin (1958) andSamuelson (1967). Network, with no amplifications: Allenand Gale 2000; Eisenberg and Noe; Gai and Kapadia 2010;Golub ea. 2013; Acemoglu 2013.
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Insight 1: Network density.In continuous-time dynamics
Optimal diversification is inte-rior:
Continuous stochasticdynamics with trendreinforcement[Battiston, Delli Gatti, Gallegati, Stiglitz,
Greenwald, 2012, JEDC (Liaisons
Dangereuses)]
Continuous stochasticdynamics in bank-assetnetwork[Tasca-Battiston 2012; 2013]
0 25 50 75 1000
0.05
0.1
0.15
Diversification degree k
De
fau
lt p
rob
ab
ility
Pf
α ↑
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Insight 1: Network density - In default cascades models
b market illiquidity, m averagetier-1 capital ratio
Interplay: diversification,amplifications (illiquidity, firesales), allocation of capitalbuffers, topology (scale-free vsrandom)
b = 0: cascade size decreaseswith k[Gai and Kapadia 2010, Golub ea. 2013; Acemoglu
2013)]
b > 0: cascade size nonmonotonic[Battiston ea., 2012 JFS; Roukny ea. SciRep 2013]
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
What Optimal Network Architecture?
1 Topology
2 Tier-1 capital vs degree (no. of contracts)
3 Asset market liquidity and bank liquidity
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Insight 3: Limitations of Default Cascades Models
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Insight 3: Limitations of Default Cascades Models
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Insight 3: Limitations of Default Cascades Models
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Insight 3: Limitations of Default Cascades Models
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Insight 3: Run of Short Term Lenders
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Insight 3: Run of Short Term Lenders
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Insight 3: Run of Short Term Lenders
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Insight 3: Interconnectedness in stress-tests
Stress tests based on cascades:
With no amplification
cascades almost never occurhigh enough diversification: no cascades at all. Recipe: fulldiversification is best.
When additional externalities at work: e.g. fire-sales, creditruns, market procyclicality, illiquidity
cascades do occur (including bank-asset network sheds light)diversification has non-monotonic effectthere is no single topology that is just superiorthe most robust architecture depends on: market liquidity,types of shocks, correlations btw capital buffer and degree
[Battiston, Delli Gatti, Gallegati, Greenwald, Stiglitz, 2012 JFS; Roukny, Bersini,
Pirotte, Caldarelli, Battiston, 2013; Tasca, Battiston 2012, ETH RC; Battiston,
Puliga, Kaushik, Tasca, Caldarelli 2012 Sci Rep]
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Insight 4: Quantifying SIFI’s: DebtRank
DebtRankmore central = moresystemically important
not just a ranking, butmonetary value of systemicloss
overcome limitations ofstate-of-the art:
1 default-only algo2 (2) non-specific measures
(between. eigenvec.,PageRank ...)
individual and groups;complement to Early WarningSystem
[Battiston ea., DebtRank 2012, Sci Rep. 2:541]Di Iasio ea. 2013 Capital and Contagion, MPR
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Insight 4: Quantifying SIFI’s: DebtRank
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Insight 4: Quantifying SIFI’s: DebtRank
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Insight 4: Quantifying SIFI’s: DebtRank
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Properties of Default vs Distress Propagation Indicators
DebtRank:
hj ∈ [0, 1] = fraction of evaporated equity
hj(0) = 1 except for the shocked banks
hi (t) = min
{1, hi (t − 1) +
∑j
Wjihj(t − 1)χj
}, where
Wji =Aij
Ei
χj = 1 if hj(t − 1) > 0 and 0 else
Dri =∑
j hj(T )Ej(0) = DR-Impact
hi (T ) = DR-Vulnerability
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Properties of Default vs Distress Propagation Indicators
Default Cascades
hj monotonously decreasing with equity of target node
hj non monotonously decreasing with total equity in thesystem
hj non sub-additive: hj(φ1 + φ2) > hj(φ1) + hj(φ2) ifφ1 + φ2 > 1 and φ1 < 1, φ2 < 1
Debt Rank
hj monotonously decreasing with equity of target node andincreasing with shock size
hj is non (?) monotonously decreasing with total equity in thesystem
hj is sub-additive: hj(φ1 + φ2) ≤ hj(φ1) + hj(φ2)
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Application: an exercise on FED data + BvD data
Take banks’ investment in each others equity share as a proxyof all exposures
Focus on the largest borrowers from the FED in 2008-2010
22 inst., peak lending 1.2 USD trillions, total assets 20 USDtrillions)
Incorporate dynamics of core capital (take marketcapitalization as a proxy of core capital)
Recipe
1 market capitalization as proxy of core capital
2 investments in equity as proxy of financial exposures
3 rescaling factor α, conservative scenario: in good the timesevery bank can sustain the default of at least 5 counterparties
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Debt Rank vs other Measures
200 400 600 800 10000
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btR
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k
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Debt Rank vs other Measures
200 400 600 800 10000
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Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Debt Rank vs other Measures
200 400 600 800 10000
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Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Latent Correlations: Shock to a Common External Asset
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Latent Correlations: Shock to a Common External Asset
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Latent Correlations: Shock to a Common External Asset
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Network Effects
For regulators: measuring the systemic impact of the distressof one or more institutions
beyond default-only chains
For investors: evaluating counterparty risk beyondcorrelationNo network effects:
correlation ρ = 0: probability of joint defaults is pN
correlation ρ = 1: probability of joint defaults is p
With network effects
probability of joint defaults can be p (and not pN) even withlow correlationpotential massive underestimation of Value-at-Risk
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Network Effects
For regulators: measuring the systemic impact of the distressof one or more institutions
beyond default-only chains
For investors: evaluating counterparty risk beyondcorrelationNo network effects:
correlation ρ = 0: probability of joint defaults is pN
correlation ρ = 1: probability of joint defaults is p
With network effects
probability of joint defaults can be p (and not pN) even withlow correlationpotential massive underestimation of Value-at-Risk
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Network Effects
For regulators: measuring the systemic impact of the distressof one or more institutions
beyond default-only chains
For investors: evaluating counterparty risk beyondcorrelationNo network effects:
correlation ρ = 0: probability of joint defaults is pN
correlation ρ = 1: probability of joint defaults is p
With network effects
probability of joint defaults can be p (and not pN) even withlow correlationpotential massive underestimation of Value-at-Risk
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Network Effects
Theorem (conjecture!): No-Systemic Risk is a Self-negatingProfecy
Systemic events may emerge precisely because financial actorsassume away systemic events.
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Network Effects
Theorem (conjecture!): No-Systemic Risk is a Self-negatingProfecy
Systemic events may emerge precisely because financial actorsassume away systemic events.
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Insight 5: How do we contain systemic risk?
Systemic risk: there exist a bad equilibrium with a combination
high interconnectedness/ interdependence
high correlation on bank behaviour
high illiquidity
high complexity of instruments and structure
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Insight 6: International Nexus of TBTF Institutions
TBTF - too-big-too-fail
TCTF -too-connected-to-fail
TCTF - too-central-to-fail
Should we regard financialinstitutions as aninternational nexus?
Sustainability: need to copewith global moral hazard.
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Insight 6: International Nexus of TBTF Institutions
TBTF - too-big-too-fail
TCTF -too-connected-to-fail
TCTF - too-central-to-fail
Should we regard financialinstitutions as aninternational nexus?
Sustainability: need to copewith global moral hazard.
200 400 600 800 10000
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0.2
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Time (days)D
ebtR
ank
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Insight 6: International Nexus of TBTF Institutions
TBTF - too-big-too-fail
TCTF -too-connected-to-fail
TCTF - too-central-to-fail
Should we regard financialinstitutions as aninternational nexus?
Sustainability: need to copewith global moral hazard.
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Insight 7: Tools for Surveillance
A coordinate effort on data gathering: it would be possible tomake tentative estimations of systemic impact of shocks
direct effect on balance sheets
amplifications via procyclical leverage-price dynamics
amplifications via balance-sheet distress propagation
Workflow
Monitor over time interconnectedness in exposures
bank-bank, bank-asset, bank-firms, country-country
Estimate networks whereas data are missing
Compute systemic risk, conditional to given distribution ofshocks
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Monitoring: proof of concept
Live daily monitoring of DebtRank on the GSIFI correlationnetwork http://ethz.focproject.eu/lwidgetnets
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Monitoring: proof of concept
Live daily monitoring of DebtRank on the GSIFI correlationnetwork http://ethz.focproject.eu/gsifi
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Monitoring: proof of concept
Co-occurrence of terms in financial blogs. Ex: “IMF” and“Ukraine” http://www.focproject.eu/focjsiwidget
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Issues on Systemic Risk Measures
VAR and ES are likely to be heavily underestimated
VAR and ES do not account interdependence. No analyticalsolution. Numerical work.VAR of a bank in isolation differs from VAR of a bank in anetworksystemic VAR of a network of interconnected banks from VARof aggregated system
Risk measures are blind1 to asset overvaluation2 network effects3 procyclical effects
risk: the whole exercise might give new but false sense ofsecurity
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Related International Activities
FOC Forecasting Financial Crises www.focproject.eu
MULTIPLEX Multi-level Complex Networks www.multiplexproject.eu
GSDP Global Systems and Policies
GSS Global Systems Science http://global-systems-science.eu/
SIMPOL (Financial Systems Simulation and Policy Modelingwww.simpol.eu
INET - Financial stability Programhttp://ineteconomics.org/research-programs/financial-stability
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Related International Activities
European Conference on Complex Systems, Lucca September22-26
Satellite workshop 24 September, Global systems science andpolicy modeling: financial networks, inequality, sustainability
http://www.eccs14.eu/
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
References - 1
Anand, K., Gai, P., Kapadia, S., Brennan, S. and Willison, M. A network modelof financial system resilience. J. Econ. Behav. Organ. 85, 219–235 (2013).
Battiston, S., Puliga, M., Kaushik, R., Tasca, P. and Caldarelli, G. DebtRank:Too Central to Fail? Financial Networks, the FED and Systemic Risk. Sci. Rep.2, (2012).
Battiston, S., Gatti, D. D., Gallegati, M., Greenwald, B. C. N. and Stiglitz, J. E.Liaisons Dangereuses: Increasing Connectivity, Risk Sharing, and Systemic Risk.J. Econ. Dyn. Control 36, 1121–1141 (2012).
Cifuentes, R., Ferrucci, G. and Shin, H. S. Liquidity risk and contagion. J. Eur.Econ. Assoc. 3, 556–566 (2005).
Eisenberg, L. and Noe, T. H. Systemic Risk in Financial Systems. Manage. Sci.47, 236–249 (2001).
Elsinger, H., Lehar, A. and Summer, M. Risk Assessment for Banking Systems.Manage. Sci. 52, 1301–1314 (2006).
Gai, P. and Kapadia, S. Contagion in financial networks. Proc. R. Soc. A Math.Phys. Eng. Sci. 466, 2401–2423 (2010).
Gai, P., Haldane, A., Kapadia, S. Complexity, concentration and contagion. J.Monet. Econ. 58, 453–470 (2011).
Haldane, A. G. Rethinking Financial Networks. Speech Financial Student Assoc.Amsterdam (2009).
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
References - 2
Haldane, A. G. Rethinking Financial Networks. Speech Financial Student Assoc.Amsterdam (2009).
Hommes C., van der Leij M., in’t Veld D., Formation of a core-peripherynetwork in OTC markets
Kubler, F. , Schmedders, K. Stationary Equilibria in Asset-Pricing Models withIncomplete Markets and Collateral. Econometrica 71, 1767–1793 (2003).
Roukny, T., Bersini, H., Pirotte, H., Caldarelli, G., Battiston, S. DefaultCascades in Complex Networks: Topology and Systemic Risk. Sci. Rep. 3,(2013).
Tasca, P., Battiston, S. Market Procyclicality and Systemic Risk. Submitt.earlier version ETH Risk Cent. Work. Pap. Ser. ETH-RC-12-012 (2012).
Tasca, P., Battiston, S. Diversification and Financial Stability. Submitt. earlierversion ETH Risk Cent. Work. Pap. Ser. ETH-RC-12-013 (2012).
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges
Introduction Network Insights Surveillance Open issues
Recent Papers
Debtrank: [Battiston, Puliga, Kaushik, Tasca, Caldarelli, DebtRank:Too-central-to-fail? (2012) Sci. Rep. 2:541]
Complex derivatives [ Battiston, Caldarelli, Georg, May, Stiglitz, Nat. Phys.,2013]
CDS and network reconstruction [Kaushik R., Battiston S., 2013 PLoS-ONE,forth], [Puliga M., Kaushik R., Battiston S., Caldarelli G., 2013 in progress]
Estimation of systemic risk in networks from partial information: [Musmeci,Puliga, Gabrielli, Battiston, Caldarelli, JOSS 2013, forth.]
Controllability in e-mid [Delpini, Battiston, Riccaboni, Pammolli, Gabbi,Caldarelli, Sci. Rep., 2013, forth.]
Controllability in TARGET2 [Galbiati, Delpini, Battiston, (2013) Nat Phys]
All works supported by FOC are available atwww.focproject.eu/publications
Stefano Battiston Measuring systemic risk in financial networks: Progress and challenges