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Liaisons Dangereuses: Increasing Connectivity, Risk Sharing, and Systemic Risk

Stefano Battiston; Domenico Delli Gatti; Mauro Gallegati; Bruce C. Greenwald; Joseph E. Stiglitz

Title:
Liaisons Dangereuses: Increasing Connectivity, Risk Sharing, and Systemic Risk
Author(s):
Battiston, Stefano; Delli Gatti, Domenico; Gallegati, Mauro; Greenwald, Bruce C.; Stiglitz, Joseph E.
Date:
Type:
Articles
Department:
Initiative for Policy Dialogue
Permanent URL:
Notes:
The opinions expressed in these papers represent those of the author(s) and not The Initiative for Policy Dialogue. These papers are unpublished and have not been peer reviewed. Please do not cite without explicit permission from the author(s).
Abstract:
We characterize the evolution over time of a network of credit relations among financial agents as a system of coupled stochastic processes. Each process describes the dynamics of individual financial robustness, while the coupling results from a network of liabilities among agents. The average level of risk diversification of the agents coincides with the density of links in the network. In addition to a process of diffusion of financial distress, we also consider a discrete process of default cascade, due to the re-evaluation of agents' assets. In this framework we investigate the probability of individual defaults as well as the probability of systemic default as a function of the network density. While it is usually thought that diversification of risk always leads to a more stable financial system, in our model a tension emerges between individual risk and systemic risk. As the number of counterparties in the credit network increases beyond a certain value, the default probability, both individual and systemic, starts to increase. This tension originates from the fact that agents are subject to a financial accelerator mechanism. In other words, individual financial fragility feeding back on itself may amplify the effect of an initial shock and lead to a full fledged systemic crisis. The results offer a simple possible explanation for the endogenous emergence of systemic risk in a credit network.
Subject(s):
Economics
Item views:
165
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