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Default Cascades: When Does Risk Diversification Increase Stability?

  • Stefano Battiston

    ()

  • Domenico Delli Gatti
  • Mauro Gallegati
  • Bruce Greenwald
  • Joseph E. Stiglitz

We explore the dynamics of default cascades in a network of credit interlinkages in which each agent is at the same time a borrower and a lender. When some counterparties of an agent default, the loss she experiences amounts to her total exposure to those counterparties. A possible conjecture in this context is that individual risk diversification across more numerous counterparties should make also systemic defaults less likely. We show that this view is not always true. In particular, the diversification of credit risk across many borrowers has ambiguous effects on systemic risk in the presence of mechanisms of loss amplifications such as in the presence of potential runs among the short-term lenders of the agents in the network.

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Paper provided by ETH Zurich, Chair of Systems Design in its series Working Papers with number ETH-RC-11-006.

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Handle: RePEc:stz:wpaper:eth-rc-11-006
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  1. Battiston, Stefano & Delli Gatti, Domenico & Gallegati, Mauro & Greenwald, Bruce & Stiglitz, Joseph E., 2012. "Liaisons dangereuses: Increasing connectivity, risk sharing, and systemic risk," Journal of Economic Dynamics and Control, Elsevier, vol. 36(8), pages 1121-1141.
  2. Franklin Allen & Ana Babus & Elena Carletti, 2010. "Financial Connections and Systemic Risk," Economics Working Papers ECO2010/26, European University Institute.
  3. Furfine, Craig H, 2003. " Interbank Exposures: Quantifying the Risk of Contagion," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 35(1), pages 111-28, February.
  4. Joseph E. Stiglitz, 2010. "Risk and Global Economic Architecture: Why Full Financial Integration May Be Undesirable," NBER Working Papers 15718, National Bureau of Economic Research, Inc.
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  7. Acharya, Viral V, 2009. "A Theory of Systemic Risk and Design of Prudential Bank Regulation," CEPR Discussion Papers 7164, C.E.P.R. Discussion Papers.
  8. Helmut Elsinger & Alfred Lehar & Martin Summer, 2002. "Risk Assessment for Banking Systems," Working Papers 79, Oesterreichische Nationalbank (Austrian Central Bank).
  9. Shin, Hyun Song, 2008. "Risk and liquidity in a system context," Journal of Financial Intermediation, Elsevier, vol. 17(3), pages 315-329, July.
  10. Bartram, Sohnke M. & Brown, Gregory W. & Hund, John E., 2007. "Estimating systemic risk in the international financial system," Journal of Financial Economics, Elsevier, vol. 86(3), pages 835-869, December.
  11. Iori, Giulia & Jafarey, Saqib & Padilla, Francisco G., 2006. "Systemic risk on the interbank market," Journal of Economic Behavior & Organization, Elsevier, vol. 61(4), pages 525-542, December.
  12. Wagner, Wolf, 2010. "Diversification at financial institutions and systemic crises," Journal of Financial Intermediation, Elsevier, vol. 19(3), pages 373-386, July.
  13. Gai, Prasanna & Kapadia, Sujit, 2010. "Contagion in financial networks," Bank of England working papers 383, Bank of England.
  14. Upper, Christian, 2011. "Simulation methods to assess the danger of contagion in interbank markets," Journal of Financial Stability, Elsevier, vol. 7(3), pages 111-125, August.
  15. Markus K. Brunnermeier & Lasse Heje Pedersen, 2007. "Market liquidity and funding liquidity," LSE Research Online Documents on Economics 24478, London School of Economics and Political Science, LSE Library.
  16. Markus K. Brunnermeier, 2008. "Deciphering the Liquidity and Credit Crunch 2007-08," NBER Working Papers 14612, National Bureau of Economic Research, Inc.
  17. Michael Boss & Martin Summer & Stefan Thurner, 2004. "Contagion Flow Through Banking Networks," Papers cond-mat/0403167, arXiv.org.
  18. Larry Eisenberg & Thomas H. Noe, 2001. "Systemic Risk in Financial Systems," Management Science, INFORMS, vol. 47(2), pages 236-249, February.
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