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

Stefano Battiston, Domenico Delli Gatti, Mauro Gallegati, Bruce C. Greenwald and Joseph Stiglitz

No 15611, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: C63 E32 G01 G32 (search for similar items in EconPapers)
Date: 2009-01
Note: EFG
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (83)

Published as 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.

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Journal Article: Liaisons dangereuses: Increasing connectivity, risk sharing, and systemic risk (2012)
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