Working Paper: NBER ID: w18727
Authors: Daron Acemoglu; Asuman Ozdaglar; Alireza Tahbazsalehi
Abstract: We provide a framework for studying the relationship between the financial network architecture and the likelihood of systemic failures due to contagion of counterparty risk. We show that financial contagion exhibits a form of phase transition as interbank connections increase: as long as the magnitude and the number of negative shocks affecting financial institutions are sufficiently small, more "complete" interbank claims enhance the stability of the system. However, beyond a certain point, such interconnections start to serve as a mechanism for propagation of shocks and lead to a more fragile financial system. We also show that, under natural contracting assumptions, financial networks that emerge in equilibrium may be socially inefficient due to the presence of a network externality: even though banks take the effects of their lending, risk-taking and failure on their immediate creditors into account, they do not internalize the consequences of their actions on the rest of the network.
Keywords: systemic risk; financial networks; contagion; stability
JEL Codes: D85; G01
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| interbank connections (F65) | financial contagion exhibits phase transition (F65) |
| interbank liabilities (F65) | likelihood of contagion (F65) |
| equilibrium financial networks (D53) | social inefficiency due to network externalities (D85) |