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Densely Entangled Financial Systems

  • Bhaskar DasGupta
  • Lakshmi Kaligounder
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    In [1] Zawadoski introduces a banking network model in which the asset and counter-party risks are treated separately and the banks hedge their assets risks by appropriate OTC contracts. In his model, each bank has only two counter-party neighbors, a bank fails due to the counter-party risk only if at least one of its two neighbors default, and such a counter-party risk is a low probability event. Informally, the author shows that the banks will hedge their asset risks by appropriate OTC contracts, and, though it may be socially optimal to insure against counter-party risk, in equilibrium banks will {\em not} choose to insure this low probability event. In this paper, we consider the above model for more general network topologies, namely when each node has exactly 2r counter-party neighbors for some integer r>0. We extend the analysis of [1] to show that as the number of counter-party neighbors increase the probability of counter-party risk also increases, and in particular the socially optimal solution becomes privately sustainable when each bank hedges its risk to at least n/2 banks, where n is the number of banks in the network, i.e., when 2r is at least n/2, banks not only hedge their asset risk but also hedge its counter-party risk.

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    File URL: http://arxiv.org/pdf/1402.5208
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    Paper provided by arXiv.org in its series Papers with number 1402.5208.

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    Date of creation: Feb 2014
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    Handle: RePEc:arx:papers:1402.5208
    Contact details of provider: Web page: http://arxiv.org/

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    1. F.R. Liedorp & L. Medema & M. Koetter & R.H. Koning & I. van Lelyveld, 2010. "Peer monitoring or contagion? Interbank market exposure and bank risk," DNB Working Papers 248, Netherlands Central Bank, Research Department.
    2. Bisin, A. & Guaitoli, D., 1998. "Moral Hazard and Non-Exclusive Contracts," Working Papers 98-24, C.V. Starr Center for Applied Economics, New York University.
    3. X. Freixas & B. Parigi & J-C. Rochet, 2000. "Systemic Risk, Interbank Relations and Liquidity Provision by theCentral Bank," DNB Staff Reports (discontinued) 47, Netherlands Central Bank.
    4. Nier, Erlend & Yang, Jing & Yorulmazer, Tanju & Alentorn, Amadeo, 2008. "Network models and financial stability," Bank of England working papers 346, Bank of England.
    5. René M. Stulz, 2009. "Credit Default Swaps and the Credit Crisis," NBER Working Papers 15384, National Bureau of Economic Research, Inc.
    6. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
    7. Gai, Prasanna & Kapadia, Sujit, 2010. "Contagion in financial networks," Bank of England working papers 383, Bank of England.
    8. Adam Zawadowski, 2013. "Entangled Financial Systems," Review of Financial Studies, Society for Financial Studies, vol. 26(5), pages 1291-1323.
    9. Ana Babus, 2007. "The Formation of Financial Networks," Working Papers 2007.69, Fondazione Eni Enrico Mattei.
    10. repec:cup:cbooks:9780521583626 is not listed on IDEAS
    11. Arora, Navneet & Gandhi, Priyank & Longstaff, Francis A., 2012. "Counterparty credit risk and the credit default swap market," Journal of Financial Economics, Elsevier, vol. 103(2), pages 280-293.
    12. Ricardo J. Caballero & Alp Simsek, 2009. "Complexity and Financial Panics," NBER Working Papers 14997, National Bureau of Economic Research, Inc.
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