Systemic Risk and Stability in Financial Networks
47 Pages Posted: 5 Feb 2013
There are 4 versions of this paper
Systemic Risk and Stability in Financial Networks
Systemic Risk and Stability in Financial Networks
Innovation, Reallocation and Growth
Systemic Risk and Stability in Financial Networks
Date Written: January 1, 2013
Abstract
We provide a framework for studying the relationship between the financial network architecture and the likelihood of systemic failures due to contagion of counterparty risk. We show that financial contagion exhibits a form of phase transition as interbank connections increase: as long as the magnitude and the number of negative shocks affecting financial institutions are sufficiently small, more “complete” interbank claims enhance the stability of the system. However, beyond a certain point, such interconnections start to serve as a mechanism for propagation of shocks and lead to a more fragile financial system. We also show that, under natural contracting assumptions, financial networks that emerge in equilibrium may be socially inefficient due to the presence of a network externality: even though banks take the effects of their lending, risk-taking and failure on their immediate creditors into account, they do not internalize the consequences of their actions on the rest of the network.
Keywords: Contagion, counterparty risk, financial network, systemic risk
JEL Classification: G01, D85
Suggested Citation: Suggested Citation