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

29 Pages Posted: 11 Jan 2010 Last revised: 29 Aug 2010

See all articles by Stefano Battiston

Stefano Battiston

University of Zurich - Department of Banking and Finance; Swiss Finance Institute

Domenico Delli Gatti

Universita' Cattolica, Milano

Mauro Gallegati

Università Politecnica delle Marche - Faculty of Economics

Bruce C. N. Greenwald

Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)

Joseph E. Stiglitz

Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)

Date Written: January 2009

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.

Suggested Citation

Battiston, Stefano and Delli Gatti, Domenico and Gallegati, Mauro and Greenwald, Bruce and Stiglitz, Joseph E., Liaisons Dangereuses: Increasing Connectivity, Risk Sharing, and Systemic Risk (January 2009). NBER Working Paper No. w15611. Available at SSRN: https://ssrn.com/abstract=1532069

Stefano Battiston (Contact Author)

University of Zurich - Department of Banking and Finance ( email )

Andreasstrasse 15
Zürich, 8050
Switzerland

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Domenico Delli Gatti

Universita' Cattolica, Milano ( email )

20123 Milano
Italy
+39 02 72342499 (Phone)
+39 02 72342923 (Fax)

Mauro Gallegati

Università Politecnica delle Marche - Faculty of Economics ( email )

Piazzale Martelli, 8
60121 Ancona
Italy
++390712207188 (Phone)
++390712207102 (Fax)

Bruce Greenwald

Columbia Business School - Finance and Economics ( email )

3022 Broadway
405b Uris, Dept. of Finance & Economics
New York, NY 10027
United States
(212) 854-5553 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Joseph E. Stiglitz

Columbia Business School - Finance and Economics ( email )

3022 Broadway
814 Uris Hall
New York, NY 10027
United States
(212) 854-0671 (Phone)
(212) 662-8474 (Fax)

HOME PAGE: http://www.josephstiglitz.com

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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