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Stability analysis of financial contagion due to overlapping portfolios

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  • Fabio Caccioli
  • Munik Shrestha
  • Cristopher Moore
  • J. Doyne Farmer

Abstract

Common asset holdings are widely believed to have been the primary vector of contagion in the recent financial crisis. We develop a network approach to the amplification of financial contagion due to the combination of overlapping portfolios and leverage, and we show how it can be understood in terms of a generalized branching process. By studying a stylized model we estimate the circumstances under which systemic instabilities are likely to occur as a function of parameters such as leverage, market crowding, diversification, and market impact. Although diversification may be good for individual institutions, it can create dangerous systemic effects, and as a result financial contagion gets worse with too much diversification. Under our model there is a critical threshold for leverage; below it financial networks are always stable, and above it the unstable region grows as leverage increases. The financial system exhibits "robust yet fragile" behavior, with regions of the parameter space where contagion is rare but catastrophic whenever it occurs. Our model and methods of analysis can be calibrated to real data and provide simple yet powerful tools for macroprudential stress testing.

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File URL: http://arxiv.org/pdf/1210.5987
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Bibliographic Info

Paper provided by arXiv.org in its series Papers with number 1210.5987.

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Date of creation: Oct 2012
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Handle: RePEc:arx:papers:1210.5987

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Web page: http://arxiv.org/

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  1. Co-Pierre Georg, 2010. "The effect of the interbank network structure on contagion and financial stability," Global Financial Markets Working Paper Series 12-2010, Friedrich-Schiller-University Jena.
  2. Allen, Franklin & Babus, Ana & Carletti, Elena, 2011. "Asset Commonality, Debt Maturity and Systemic Risk," CEPR Discussion Papers, C.E.P.R. Discussion Papers 8476, C.E.P.R. Discussion Papers.
  3. Nier, Erlend & Yang, Jing & Yorulmazer, Tanju & Alentorn, Amadeo, 2008. "Network models and financial stability," Bank of England working papers, Bank of England 346, Bank of England.
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Cited by:
  1. Teruyoshi Kobayashi & Kohei Hasui, 2013. "Efficient immunization strategies to prevent financial contagion," Papers 1308.0652, arXiv.org, revised Dec 2013.
  2. Charles D. Brummitt & Rajiv Sethi & Duncan J. Watts, 2014. "Inside Money, Procyclical Leverage, and Banking Catastrophes," Papers 1403.1637, arXiv.org.

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