Systemic Risk and Stability in Financial Networks
AbstractWe provide a framework for studying the relationship between the financial network architecture and the likelihood of systemic failures due to contagion of counterparty risk. We show that financial contagion exhibits a form of phase transition as interbank connections increase: as long as the magnitude and the number of negative shocks affecting financial institutions are sufficiently small, more “complete” interbank claims enhance the stability of the system. However, beyond a certain point, such interconnections start to serve as a mechanism for propagation of shocks and lead to a more fragile financial system. We also show that, under natural contracting assumptions, financial networks that emerge in equilibrium may be socially inefficient due to the presence of a network externality: even though banks take the effects of their lending, risk-taking and failure on their immediate creditors into account, they do not internalize the consequences of their actions on the rest of the network.
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Date of creation: Jan 2013
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Find related papers by JEL classification:
- D85 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Network Formation
- G01 - Financial Economics - - General - - - Financial Crises
This paper has been announced in the following NEP Reports:
- NEP-ALL-2013-02-03 (All new papers)
- NEP-BAN-2013-02-03 (Banking)
- NEP-CBA-2013-02-03 (Central Banking)
- NEP-NET-2013-02-03 (Network Economics)
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