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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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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

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

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References

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  1. Shin, Hyun Song, 2008. "Risk and liquidity in a system context," Journal of Financial Intermediation, Elsevier, vol. 17(3), pages 315-329, July.
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  13. Battiston, Stefano & Delli Gatti, Domenico & Gallegati, Mauro & Greenwald, Bruce & Stiglitz, Joseph E., 2012. "Liaisons dangereuses: Increasing connectivity, risk sharing, and systemic risk," Journal of Economic Dynamics and Control, Elsevier, vol. 36(8), pages 1121-1141.
  14. Castiglionesi, F. & Navarro, N., 2007. "Optimal Fragile Financial Networks," Discussion Paper 2007-100, Tilburg University, Center for Economic Research.
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  17. Wagner, W.B., 2006. "Diversification at Financial Institutions and Systemic Crises," Discussion Paper 2006-71, Tilburg University, Center for Economic Research.
  18. Upper, Christian, 2011. "Simulation methods to assess the danger of contagion in interbank markets," Journal of Financial Stability, Elsevier, vol. 7(3), pages 111-125, August.
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