Cambridge, MA: Department of Economics, massachusetts Institute of Technology
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.We are grateful to David Brown, Ozan Candogan, Gary Gorton, Ali Jadbabaie, Jean-Charles Rochet, Alp Simsek, Ali Shourideh and Rakesh Vohra for useful feedback and suggestions. We also thank seminar participants at the 2012 and 2013 AEA Conferences, Chicago Booth, MIT, Stanford GSB, and the Systemic Risk conference at the Goethe University. Acemoglu and Ozdaglar gratefully acknowledge financial support from the Army Research Office, Grant MURI W911NF-12-1-0509
