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Optimal Fragile Financial Networks

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  • Castiglionesi, F.
  • Navarro, N.

    (Tilburg University, Center for Economic Research)

Abstract

We study a financial network characterized by the presence of depositors, banks and their shareholders. Belonging to a financial network is beneficial for both the depositors and banks' shareholders since the return to investment increases with the number of banks connected. However, the network is fragile since banks, which invest on behalf of the depositors, can gamble with depositors' money (making an investment that is dominated in expected terms) when not sufficiently capitalized. The bankruptcy of a bank negatively affects the banks connected to it in the network. First, we compute the social planner solution and the efficient financial network is characterized by a core-periphery structure. Second, we analyze the decentralized solution showing under which conditions participating in a fragile financial network is ex-ante optimal. In particular, we show that this is optimal when the probability of bankruptcy is sufficiently low giving rationale of financial fragility as a rare phenomenon. Finally, we analyze the efficiency of the decentralized financial network. Again, if the probability of bankruptcy is sufficiently low the structure of the decentralized financial network is equal to the e¢ cient one, yielding an ex- pected payo¤ arbitrarily close to the efficient one. However, the investment decision is not the same. That is, in the decentralized network some banks will gamble as compared to the socially preferred outcome.

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Bibliographic Info

Paper provided by Tilburg University, Center for Economic Research in its series Discussion Paper with number 2007-100.

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Date of creation: 2007
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Handle: RePEc:dgr:kubcen:2007100

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Web page: http://center.uvt.nl

Related research

Keywords: Financial Network; Moral Hazard; Financial Fragility;

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References

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  1. Franklin Allen & Douglas Gale, 2003. "Financial Intermediaries and Markets," Center for Financial Institutions Working Papers 00-44, Wharton School Center for Financial Institutions, University of Pennsylvania.
  2. Franklin Allen & Douglas Gale, 1998. "Financial Contagion Journal of Political Economy," Center for Financial Institutions Working Papers 98-31, Wharton School Center for Financial Institutions, University of Pennsylvania.
  3. Matthew O. Jackson & Asher Wolinsky, 1995. "A Strategic Model of Social and Economic Networks," Discussion Papers 1098R, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  4. Rochet, Jean-Charles & Tirole, Jean, 1996. "Interbank Lending and Systemic Risk," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(4), pages 733-62, November.
  5. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.
  6. 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, pages 611-640.
  7. Ana Babus, 2007. "The Formation of Financial Networks," Working Papers 2007.69, Fondazione Eni Enrico Mattei.
  8. Sandro Brusco & Fabio Castiglionesi, 2005. "Liquidity Coinsurance, Moral Hazard and Financial Contagion," Department of Economics Working Papers 05-12, Stony Brook University, Department of Economics.
  9. Aghion, Philippe & Bolton, Patrick & Dewatripont, Mathias, 2000. "Contagious bank failures in a free banking system," European Economic Review, Elsevier, vol. 44(4-6), pages 713-718, May.
  10. Yaron Leitner, 2005. "Financial Networks: Contagion, Commitment, and Private Sector Bailouts," Journal of Finance, American Finance Association, vol. 60(6), pages 2925-2953, December.
  11. Douglas M. Gale & Shachar Kariv, 2007. "Financial Networks," American Economic Review, American Economic Association, vol. 97(2), pages 99-103, May.
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