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Default cascades: When does risk diversification increase stability?

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Author Info

  • 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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Bibliographic Info

Article provided by Elsevier in its journal Journal of Financial Stability.

Volume (Year): 8 (2012)
Issue (Month): 3 ()
Pages: 138-149

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Handle: RePEc:eee:finsta:v:8:y:2012:i:3:p:138-149

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Web page: http://www.elsevier.com/locate/jfstabil

Related research

Keywords: Systemic risk; Network models; Contagion; Financial crisis;

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Cited by:
  1. Josselin Garnier & George Papanicolaou & Tzu-Wei Yang, 2012. "Large deviations for a mean field model of systemic risk," Papers 1204.3536, arXiv.org, revised Aug 2012.
  2. Rahul Kaushik & Stefano Battiston, 2012. "Credit Default Swaps Drawup Networks: Too Tied To Be Stable?," Papers 1205.0976, arXiv.org.
  3. Rahul Kaushik & Stefano Battiston, . "Credit Default Swaps Drawup Networks: Too Tied To Be Stable?," Working Papers ETH-RC-12-013, ETH Zurich, Chair of Systems Design.
  4. Paolo Tasca & Stefano Battiston, . "Market Procyclicality and Systemic Risk," Working Papers ETH-RC-12-012, ETH Zurich, Chair of Systems Design.
  5. Matteo Chinazzi & Giorgio Fagiolo & Javier A. Reyes & Stefano Schiavo, 2012. "Post-Mortem Examination of the International Financial Network," LEM Papers Series 2012/04, Laboratory of Economics and Management (LEM), Sant'Anna School of Advanced Studies, Pisa, Italy.

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