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Risk Sharing and Contagion in Networks

Author

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  • Antonio Cabrales
  • Piero Gottardi
  • Fernando Vega-Redondo

Abstract

We investigate the socially optimal design of financial networks, that allows to tackle the trade-off between risk sharing and contagion. We identify conditions on the shock distribution under which full integration or maximal segmentation is optimal. We also show that, under different conditions, the optimal network displays different levels of strength of linkages to other firms or intermediate degrees of segmentation. In the latter case, the individual and social incentives to establish linkages are not necessarily aligned. When firms face heterogeneous distributions of risks, they should optimally form linkages only with firms facing risks of the same kind.Received November 8, 2014; editorial decision April 28, 2017 by Editor Itay Goldstein.

Suggested Citation

  • Antonio Cabrales & Piero Gottardi & Fernando Vega-Redondo, 2017. "Risk Sharing and Contagion in Networks," The Review of Financial Studies, Society for Financial Studies, vol. 30(9), pages 3086-3127.
  • Handle: RePEc:oup:rfinst:v:30:y:2017:i:9:p:3086-3127.
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    More about this item

    JEL classification:

    • D85 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Network Formation
    • C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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