Developing an Early Warning System for Financial Networks: An Explainable Machine Learning Approach

Identifying the influential variables that provide early warning of financial network instability is challenging, in part due to the complexity of the system, uncertainty of a failure, and nonlinear, time-varying relationships between network participants. In this study, we introduce a novel methodology to select variables that, from a data-driven and statistical modeling perspective, represent these relationships and may indicate that the financial network is trending toward instability. We introduce a novel variable selection methodology that leverages Shapley values and modified Borda counts, in combination with statistical and machine learning methods, to create an explainable linear model to predict relationship value weights between network participants. We validate this new approach with data collected from the March 2023 Silicon Valley Bank Failure. The models produced using this novel method successfully identified the instability trend using only 14 input variables out of a possible 3160. The use of parsimonious linear models developed by this method has the potential to identify key financial stability indicators while also increasing the transparency of this complex system.