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Financial networks: contagion, commitment, and private sector bailouts

  • Yaron Leitner
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    The author develops a model of financial networks where linkages not only spread contagion, but also induce private-sector bailouts in which liquid banks bail out illiquid banks because of the threat of contagion. Introducing this bailout possibility, the author shows that linkages may be optimal ex-ante because they allow banks to obtain some mutual insurance even though formal commitments are impossible. However, in some cases (for example, when liquidity is concentrated among a small group of banks), the whole network may collapse. The author also characterizes the optimal network size and apply the results to joint liability arrangements and payment systems.> Original working paper title: Fragile financial networks.

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    File URL: http://www.philadelphiafed.org/research-and-data/publications/working-papers/2002/wp02-9r.pdf
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    Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 02-9.

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    Date of creation: 2004
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    Publication status: Published in Journal of Finance, 60, no. 6 (December, 2005) : 2925-2953
    Handle: RePEc:fip:fedpwp:02-9
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    1. Matthew O. Jackson & Asher Wolinsky, 1995. "A Strategic Model of Social and Economic Networks," Discussion Papers 1098R, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    2. Dewatripont, M & Maskin, E, 1995. "Credit and Efficiency in Centralized and Decentralized Economies," Review of Economic Studies, Wiley Blackwell, vol. 62(4), pages 541-55, October.
    3. Douglas W. Diamond & Raghuram G. Rajan, 1999. "Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking," NBER Working Papers 7430, National Bureau of Economic Research, Inc.
    4. Franklin Allen & Douglas Gale, 1998. "Financial Contagion Journal of Political Economy," Center for Financial Institutions Working Papers 98-31, Wharton School Center for Financial Institutions, University of Pennsylvania.
    5. Jean-Charles Rochet & Jean Tirole, 1996. "Interbank lending and systemic risk," Proceedings, Board of Governors of the Federal Reserve System (U.S.), pages 733-765.
    6. Dean Corbae & John Duffy, 2003. "Experiments with Network Formation," Levine's Working Paper Archive 666156000000000319, David K. Levine.
    7. Roger D. Lagunoff & Stacey L. Schreft, 1998. "A model of financial fragility," Research Working Paper 98-01, Federal Reserve Bank of Kansas City.
    8. Rothschild, Michael & Stiglitz, Joseph E., 1970. "Increasing risk: I. A definition," Journal of Economic Theory, Elsevier, vol. 2(3), pages 225-243, September.
    9. Albert S. Kyle, 2001. "Contagion as a Wealth Effect," Journal of Finance, American Finance Association, vol. 56(4), pages 1401-1440, 08.
    10. 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.
    11. Venkatesh Bala & Sanjeev Goyal, 2000. "A Noncooperative Model of Network Formation," Econometrica, Econometric Society, vol. 68(5), pages 1181-1230, September.
    12. Besley, T. & Coate, S., 1991. "Group Lending, Repayment Incentives And Social Collateral," Papers 152, Princeton, Woodrow Wilson School - Development Studies.
    13. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.
    14. Freixas, Xavier, 1999. "Optimal Bail-Out, Conditionality and Creative Ambiguity," CEPR Discussion Papers 2238, C.E.P.R. Discussion Papers.
    15. Kremer, Michael, 1993. "The O-Ring Theory of Economic Development," The Quarterly Journal of Economics, MIT Press, vol. 108(3), pages 551-75, August.
    16. Acharya, Viral V., 2009. "A theory of systemic risk and design of prudential bank regulation," Journal of Financial Stability, Elsevier, vol. 5(3), pages 224-255, September.
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