Financial Networks and Contagion
California Institute of Technology - Division of the Humanities and Social Sciences
Matthew O. Jackson
Stanford University - Department of Economics; Santa Fe Institute; Canadian Institute for Advanced Research (CIFAR)
We model contagions and cascades of failures among organizations linked through a network of financial interdependencies. We identify how the network propagates discontinuous changes in asset values triggered by failures (e.g., bankruptcies, defaults, and other insolvencies) and use that to study the consequences of integration (each organization becoming more dependent on its counterparties) and diversification (each organization interacting with a larger number of counterparties). Integration and diversification have different, nonmonotonic effects on the extent of cascades. Initial increases in diversification connect the network which permits cascades to propagate further, but eventually, more diversification makes contagion between any pair of organizations less likely as they become less dependent on each other. Integration also faces tradeoffs: increased dependence on other organizations versus less sensitivity to own investments. Finally, we illustrate some aspects of the model with data on European debt cross-holdings.
Number of Pages in PDF File: 61
Keywords: financial networks, networks, contagion, cascades, financial crises, bankruptcy, diversification, integration, globalization
JEL Classification: G32, D85, G01, F36, G33, G38, F15
Date posted: December 10, 2012 ; Last revised: January 28, 2014
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