Working Paper: NBER ID: w15611
Authors: Stefano Battiston; Domenico Delli Gatti; Mauro Gallegati; Bruce C. Greenwald; Joseph E. Stiglitz
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.
Keywords: connectivity; risk sharing; systemic risk; credit networks
JEL Codes: C63; E32; G01; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| degree of risk diversification (h=0) (D81) | average probability of individual bankruptcy (K35) |
| degree of risk diversification (h>0) (D81) | average probability of bankruptcy (K35) |
| excessive diversification (L25) | average probability of bankruptcy (K35) |
| risk diversification (G11) | systemic risk (E44) |
| optimal level of diversification (L25) | systemic risk (E44) |
| interconnectedness among agents (D85) | financial distress (G33) |
| initial shock (Y20) | systemic crises (H12) |