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Risk-sharing and contagion in networks

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  • Antonio Cabrales

    ()

  • Piero Gottardi

    ()

  • Fernando Vega-Redondo

    ()

Abstract

The aim of this paper is to investigate how the capacity of an economic system to absorb shocks depends on the specific pattern of interconnections established among financial firms. The key trade-off at work is between the risk-sharing gains enjoyed by firms when they become more interconnected and the large-scale costs resulting from an increased risk exposure. We focus on two dimensions of the network structure: the size of the (disjoint) components into which the network is divided, and the “relative density" of connections within each component. We find that when the distribution of the shocks displays "fat" tails extreme segmentation is optimal, while minimal segmentation and high density are optimal when the distribution exhibits "thin" tails. For other, less regular distributions intermediate degrees of segmentation and sparser connections are also optimal. We also find that there is typically a conflict between efficiency and pairwise stability, due to a “size externality" that is not internalized by firms who belong to components that have reached an individually optimal size. Finally, optimality requires perfect assortativity for firms in a component.

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Bibliographic Info

Paper provided by Universidad Carlos III, Departamento de Economía in its series Economics Working Papers with number we1301.

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Date of creation: Jan 2013
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Handle: RePEc:cte:werepe:we1301

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Keywords: Firm networks; Contagion; Risk Sharing;

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  1. Helmut Elsinger & Alfred Lehar & Martin Summer, 2006. "Risk Assessment for Banking Systems," Management Science, INFORMS, INFORMS, vol. 52(9), pages 1301-1314, September.
  2. Coralio Ballester & Antoni Calvó-Armengol & Yves Zenou, 2006. "Who's Who in Networks. Wanted: The Key Player," Econometrica, Econometric Society, Econometric Society, vol. 74(5), pages 1403-1417, 09.
  3. Matthew O. Jackson & Asher Wolinsky, 1995. "A Strategic Model of Social and Economic Networks," Discussion Papers, Northwestern University, Center for Mathematical Studies in Economics and Management Science 1098R, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  4. Diebold, Francis X. & Yilmaz, Kamil, 2007. "Measuring financial asset return and volatility spillovers, with application to global equity markets," CFS Working Paper Series, Center for Financial Studies (CFS) 2007/02, Center for Financial Studies (CFS).
  5. Bloch, Francis & Genicot, Garance & Ray, Debraj, 2008. "Informal insurance in social networks," Journal of Economic Theory, Elsevier, Elsevier, vol. 143(1), pages 36-58, November.
  6. Yaron Leitner, 2005. "Financial Networks: Contagion, Commitment, and Private Sector Bailouts," Journal of Finance, American Finance Association, American Finance Association, vol. 60(6), pages 2925-2953, December.
  7. Xavier Freixas & Bruno M. Parigi & Jean-Charles Rochet, 2000. "Systemic risk, interbank relations, and liquidity provision by the central bank," Proceedings, Federal Reserve Bank of Cleveland, Federal Reserve Bank of Cleveland, pages 611-640.
  8. Paul Krugman, 1999. "Balance Sheets, the Transfer Problem, and Financial Crises," International Tax and Public Finance, Springer, Springer, vol. 6(4), pages 459-472, November.
  9. 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.
  10. Goyal, Sanjeev & Vega-Redondo, Fernando, 2007. "Structural holes in social networks," Journal of Economic Theory, Elsevier, Elsevier, vol. 137(1), pages 460-492, November.
  11. Nier, Erlend & Yang, Jing & Yorulmazer, Tanju & Alentorn, Amadeo, 2007. "Network models and financial stability," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 31(6), pages 2033-2060, June.
  12. Antoni Calvó-Armengol & Rahmi İlkılıç, 2009. "Pairwise-stability and Nash equilibria in network formation," International Journal of Game Theory, Springer, Springer, vol. 38(1), pages 51-79, March.
  13. Yann Bramoullé & Rachel Kranon, 2005. "Risk-Sharing Networks," Cahiers de recherche, CIRPEE 0526, CIRPEE.
  14. Daron Acemoglu & Asuman Ozdaglar & Alireza Tahbaz-Salehi, 2013. "Systemic Risk and Stability in Financial Networks," NBER Working Papers 18727, National Bureau of Economic Research, Inc.
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