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Risk-sharing and contagion in networks

  • Vega-Redondo, Fernando
  • Gottardi, Piero
  • Cabrales, Antonio

The aim of this paper is to investigate how the capacity of an economic system to absorb shocks depends on the specific pattern of interconnections established among financial firms. The key trade-off at work is between the risk-sharing gains enjoyed by firms when they become more interconnected and the large-scale costs resulting from an increased risk exposure. We focus on two dimensions of the network structure: the size of the (disjoint) components into which the network is divided, and the “relative density" of connections within each component. We find that when the distribution of the shocks displays "fat" tails extreme segmentation is optimal, while minimal segmentation and high density are optimal when the distribution exhibits "thin" tails. For other, less regular distributions intermediate degrees of segmentation and sparser connections are also optimal. We also find that there is typically a conflict between efficiency and pairwise stability, due to a “size externality" that is not internalized by firms who belong to components that have reached an individually optimal size. Finally, optimality requires perfect assortativity for firms in a component.

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File URL: http://e-archivo.uc3m.es/bitstream/handle/10016/16195/we1301.pdf?sequence=1
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Paper provided by Universidad Carlos III de Madrid. Departamento de Economía in its series UC3M Working papers. Economics with number we1301.

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Date of creation: 20 Jan 2013
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Handle: RePEc:cte:werepe:we1301
Contact details of provider: Web page: http://www.eco.uc3m.es/

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  1. Ballester, Coralio & Calvó-Armengol, Antoni & Zenou, Yves, 2005. "Who’s Who in Networks. Wanted: The Key Player," CEPR Discussion Papers 5329, C.E.P.R. Discussion Papers.
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  3. Nier, Erlend & Yang, Jing & Yorulmazer, Tanju & Alentorn, Amadeo, 2007. "Network models and financial stability," Journal of Economic Dynamics and Control, Elsevier, vol. 31(6), pages 2033-2060, June.
  4. Allen, Franklin & Babus, Ana & Carletti, Elena, 2011. "Asset Commonality, Debt Maturity and Systemic Risk," CEPR Discussion Papers 8476, C.E.P.R. Discussion Papers.
  5. Francis Bloch (GREQAM and Universite de la Mediterranee), Garance Genicot (Georgetown University, and Debraj Ray (New York University and Instituto de Analisis Economico (CSIC)), 2004. "Informal Insurance in Social Networks," Working Papers gueconwpa~04-04-16, Georgetown University, Department of Economics.
  6. Helmut Elsinger & Alfred Lehar & Martin Summer, 2006. "Risk Assessment for Banking Systems," Management Science, INFORMS, vol. 52(9), pages 1301-1314, September.
  7. Daron Acemoglu & Asuman Ozdaglar & Alireza Tahbaz-Salehi, 2015. "Systemic Risk and Stability in Financial Networks," American Economic Review, American Economic Association, vol. 105(2), pages 564-608, February.
  8. Paul Krugman, 1999. "Balance Sheets, the Transfer Problem, and Financial Crises," International Tax and Public Finance, Springer;International Institute of Public Finance, vol. 6(4), pages 459-472, November.
  9. Yann Bramoullé & Rachel Kranon, 2005. "Risk-Sharing Networks," Cahiers de recherche 0526, CIRPEE.
  10. Antoni Calvó-Armengol & Rahmi Ilkiliç, 2004. "Pairwise-Stability and Nash Equilibria in Network Formation," Working Papers 182, Barcelona Graduate School of Economics.
  11. Yaron Leitner, 2005. "Financial Networks: Contagion, Commitment, and Private Sector Bailouts," Journal of Finance, American Finance Association, vol. 60(6), pages 2925-2953, December.
  12. Jackson, Matthew O. & Wolinsky, Asher, 1996. "A Strategic Model of Social and Economic Networks," Journal of Economic Theory, Elsevier, vol. 71(1), pages 44-74, October.
  13. Francis X. Diebold & Kamil Yılmaz, 2007. "Measuring Financial Asset Return and Volatility Spillovers, With Application to Global Equity Markets," Koç University-TUSIAD Economic Research Forum Working Papers 0705, Koc University-TUSIAD Economic Research Forum.
  14. Edward Denbee & Christian Julliard & Ye Li & Kathy Yuan, 2014. "Network Risk and Key Players: A Structural Analysis of Interbank Liquidity," FMG Discussion Papers dp734, Financial Markets Group.
  15. H Peyton Young & Paul Glasserman, 2013. "How Likely is Contagion in Financial Networks?," Economics Series Working Papers 642, University of Oxford, Department of Economics.
  16. Goyal, Sanjeev & Vega-Redondo, Fernando, 2007. "Structural holes in social networks," Journal of Economic Theory, Elsevier, vol. 137(1), pages 460-492, November.
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