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Financial networks: contagion, commitment, and private sector bailouts

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Yaron Leitner
Abstract

The author develops a model of financial networks where linkages not only spread contagion, but also induce private-sector bailouts in which liquid banks bail out illiquid banks because of the threat of contagion. Introducing this bailout possibility, the author shows that linkages may be optimal ex-ante because they allow banks to obtain some mutual insurance even though formal commitments are impossible. However, in some cases (for example, when liquidity is concentrated among a small group of banks), the whole network may collapse. The author also characterizes the optimal network size and apply the results to joint liability arrangements and payment systems.> Original working paper title: Fragile financial networks.

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Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 02-9.

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Date of creation: 2004
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Publication status: Published in Journal of Finance, 60, no. 6 (December, 2005) : 2925-2953
Handle: RePEc:fip:fedpwp:02-9

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Keywords: Financial markets;

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Kremer, Michael, 1993. "The O-Ring Theory of Economic Development," The Quarterly Journal of Economics, MIT Press, vol. 108(3), pages 551-75, August. [Downloadable!] (restricted)
  2. Acharya, Viral V., 2009. "A Theory of Systemic Risk and Design of Prudential Bank Regulation," CEPR Discussion Papers 7164, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  3. Dewatripont, M & Maskin, E, 1995. "Credit and Efficiency in Centralized and Decentralized Economies," Review of Economic Studies, Blackwell Publishing, vol. 62(4), pages 541-55, October. [Downloadable!] (restricted)
  4. Lagunoff, Roger & Schreft, Stacey L., 2001. "A Model of Financial Fragility," Journal of Economic Theory, Elsevier, vol. 99(1-2), pages 220-264, July. [Downloadable!] (restricted)
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  5. John Duffy & Dean Corbae, 2006. "Experiments with Network Formation," Working Papers 292, University of Pittsburgh, Department of Economics, revised Aug 2007. [Downloadable!]
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  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.
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  7. Venkatesh Bala & Sanjeev Goyal, 2000. "A Noncooperative Model of Network Formation," Econometrica, Econometric Society, vol. 68(5), pages 1181-1230, September.
  8. 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. [Downloadable!]
  9. Besley, Timothy & Coate, Stephen, 1995. "Group lending, repayment incentives and social collateral," Journal of Development Economics, Elsevier, vol. 46(1), pages 1-18, February. [Downloadable!] (restricted)
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  10. Jean-Charles Rochet & Jean Tirole, 1996. "Interbank lending and systemic risk," Proceedings, Board of Governors of the Federal Reserve System (U.S.), pages 733-765.
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  11. Nobuhiro Kiyotaki & John Moore, 2004. "Credit Chains," ESE Discussion Papers 118, Edinburgh School of Economics, University of Edinburgh.
  12. Freixas, Xavier, 1999. "Optimal Bail-Out, Conditionality and Creative Ambiguity," CEPR Discussion Papers 2238, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  13. Douglas W. Diamond & Raghuram G. Rajan, 2001. "Liquidity Risk, Liquidity Creation, and Financial Fragility: A Theory of Banking," Journal of Political Economy, University of Chicago Press, vol. 109(2), pages 287-327, April. [Downloadable!] (restricted)
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  14. 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. [Downloadable!] (restricted)
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  15. 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. [Downloadable!]
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  16. Rothschild, Michael & Stiglitz, Joseph E., 1970. "Increasing risk: I. A definition," Journal of Economic Theory, Elsevier, vol. 2(3), pages 225-243, September. [Downloadable!] (restricted)
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  1. Steffen Lippert & Giancarlo Spagnolo, 2004. "Networks of Relations," Discussion Papers 28, SFB/TR 15 Governance and the Efficiency of Economic Systems, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich. [Downloadable!]
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  2. Lippert, Steffen & Spagnolo, Giancarlo, 2005. "Networks of Relations and Social Capital," CEPR Discussion Papers 5078, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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