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Risk-Sharing and Contagion in Networks

  • Antonio Cabrales
  • Piero Gottardo
  • Fernando Vega-Redondo

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://cadmus.eui.eu/bitstream/handle/1814/25634/ECO_2013_01.pdf
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Paper provided by European University Institute in its series Economics Working Papers with number ECO2013/01.

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Date of creation: 2013
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Handle: RePEc:eui:euiwps:eco2013/01
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  1. Allen, Franklin & Babus, Ana & Carletti, Elena, 2013. "Asset Commonality, Debt Maturity and Systemic Risk," Working Papers 10-30, University of Pennsylvania, Wharton School, Weiss Center.
  2. Francis Bloch & Garance Genicot, 2005. "Informal Insurance in Social Networks," 2005 Meeting Papers 156, Society for Economic Dynamics.
    • 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.
  3. Antoni Calvó-Armengol & Rahmi Ilkiliç, 2005. "Pairwise-Stability and Nash Equilibria in Network Formation," Working Papers 2005.34, Fondazione Eni Enrico Mattei.
  4. Francis X. Diebold & Kamil Yilmaz, 2007. "Measuring Financial Asset Return and Volatility Spillovers, With Application to Global Equity Markets," PIER Working Paper Archive 07-002, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
  5. H Peyton Young & Paul Glasserman, 2013. "How Likely is Contagion in Financial Networks?," Economics Series Working Papers 642, University of Oxford, Department of Economics.
  6. Freixas, Xavier & Parigi, Bruno M & Rochet, Jean-Charles, 2000. "Systemic Risk, Interbank Relations, and Liquidity Provision by the Central Bank," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(3), pages 611-38, August.
  7. 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.
  8. Goyal, Sanjeev & Vega-Redondo, Fernando, 2007. "Structural holes in social networks," Journal of Economic Theory, Elsevier, vol. 137(1), pages 460-492, November.
  9. Bramoullé, Yann & Kranton, Rachel, 2007. "Risk-sharing networks," Journal of Economic Behavior & Organization, Elsevier, vol. 64(3-4), pages 275-294.
  10. Paul Krugman, 1999. "Balance Sheets, the Transfer Problem, and Financial Crises," International Tax and Public Finance, Springer, vol. 6(4), pages 459-472, November.
  11. 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.
  12. Nier, Erlend & Yang, Jing & Yorulmazer, Tanju & Alentorn, Amadeo, 2008. "Network models and financial stability," Bank of England working papers 346, Bank of England.
  13. Daron Acemoglu & Asuman Ozdaglar & Alireza Tahbaz-Salehi, 2013. "Systemic Risk and Stability in Financial Networks," NBER Working Papers 18727, National Bureau of Economic Research, Inc.
  14. Helmut Elsinger & Alfred Lehar & Martin Summer, 2006. "Risk Assessment for Banking Systems," Management Science, INFORMS, vol. 52(9), pages 1301-1314, September.
  15. Yaron Leitner, 2005. "Financial Networks: Contagion, Commitment, and Private Sector Bailouts," Journal of Finance, American Finance Association, vol. 60(6), pages 2925-2953, December.
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