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Default cascades: When does risk diversification increase stability?

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  • Battiston, Stefano
  • Gatti, Domenico Delli
  • Gallegati, Mauro
  • Greenwald, Bruce
  • Stiglitz, Joseph E.

Abstract

We explore the dynamics of default cascades in a network of credit interlink-ages in which each agent is at the same time a borrower and a lender. When some counterparties of an agent default, the loss she experiences amounts to her total exposure to those counterparties. A possible conjecture in this context is that individual risk diversification across more numerous counterparties should make also systemic defaults less likely. We show that this view is not always true. In particular, the diversification of credit risk across many borrowers has ambiguous effects on systemic risk in the presence of mechanisms of loss amplifications such as in the presence of potential runs among the short-term lenders of the agents in the network.

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  • Battiston, Stefano & Gatti, Domenico Delli & Gallegati, Mauro & Greenwald, Bruce & Stiglitz, Joseph E., 2012. "Default cascades: When does risk diversification increase stability?," Journal of Financial Stability, Elsevier, vol. 8(3), pages 138-149.
    • Handle: RePEc:eee:finsta:v:8:y:2012:i:3:p:138-149
    DOI: 10.1016/j.jfs.2012.01.002
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    More about this item

    Keywords

    Systemic risk; Network models; Contagion; Financial crisis;
    All these keywords.

    JEL classification:

    • D85 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Network Formation
    • G01 - Financial Economics - - General - - - Financial Crises
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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