OFR Working Paper Explores Innovative Models for Analyzing Threats to Financial Stability

How might the dynamics of a flock of birds in flight, a group of drivers in a traffic jam, or a panicked crowd of stampeding people inform our analysis of threats to financial stability?

In the third paper of our Working Paper Series - Using Agent-Based Models for Analyzing Threats to Financial Stability​ - the staff of the Office of Financial Research (OFR) explores these questions as we seek better ways to monitor risk to the financial system.

Agent-Based Models, or ABMs, lie outside the academic mainstream of economics and finance, but they hold promise for capturing the dynamics of financial crises. Traditional models view the future through a lens of historical patterns. But, at times, past events offer little guidance about the course of a financial crisis, typically marked by unexpected shocks and interrelationships.

In contrast, ABMs are flexible and are not wedded to historical patterns. They seek to understand group behavior by exploring the collective effect of decision rules and expected actions by individuals. Analogously, the flight of a flock of birds appears to operate as a system, but is driven by decision rules of individual birds that are reacting to other birds in the flock.

The paper, authored by Richard Bookstaber of the OFR, discusses the concepts and research related to agent-based models. It provides a template for how these models might be applied to issues relevant to the OFR mission, such as the way shocks are transmitted through an interconnected financial system.

OFR researchers are evaluating whether these modeling approaches can help the OFR and others in probing the vulnerabilities of the financial system; understanding contagion, runs, and fire sales; and gauging the impacts of policy actions.

A key part of the mission of the OFR is to develop analytical methods for assessing risks to the financial system and to publish the results of that research. Through the Working Paper Series, the OFR is making available its research and analysis for researchers and other interested parties to review and discuss, so they can offer feedback that will foster continued strides in research aimed at improving financial stability.

The OFR Working Paper Series is available here.

Jonathan Sokobin is the Acting Deputy Director of the Research and Analysis Center and Chief of Analytical Strategy for the Office of Financial Research at the U.S. Department of the Treasury.