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

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

Liaisons Dangereuses: Increasing Connectivity, Risk Sharing, and Systemic Risk
Battiston, Stefano
Delli Gatti, Domenico
Gallegati, Mauro
Greenwald, Bruce C.
Stiglitz, Joseph E.
International and Public Affairs
Initiative for Policy Dialogue
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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.
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Suggested Citation:
Stefano Battiston, Domenico Delli Gatti, Mauro Gallegati, Bruce C. Greenwald, Joseph E. Stiglitz, , Liaisons Dangereuses: Increasing Connectivity, Risk Sharing, and Systemic Risk, Columbia University Academic Commons, .

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