Heterogeneity, Correlations and Financial Contagion

15 Pages Posted: 7 Sep 2011  

Fabio Caccioli

University College London - Financial Computing and Analytics Group, Department of Computer Science

Thomas A. Catanach

University of Notre Dame

J. Doyne Farmer

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School; Santa Fe Institute

Date Written: September 6, 2011

Abstract

We consider a model of contagion in financial networks recently introduced in the literature, and we characterize the effect of a few features empirically observed in real networks on the stability of the system. Notably, we consider the effect of heterogeneous degree distributions, heterogeneous balance sheet size and degree correlations between banks. We study the probability of contagion conditional on the failure of a random bank, the most connected bank and the biggest bank, and we consider the effect of targeted policies aimed at increasing the capital requirements of a few banks with high connectivity or big balance sheets. Networks with heterogeneous degree distributions are shown to be more resilient to contagion triggered by the failure of a random bank, but more fragile with respect to contagion triggered by the failure of highly connected nodes. A power law distribution of balance sheet size is shown to induce an inefficient diversification that makes the system more prone to contagion events. A targeted policy aimed at reinforcing the stability of the biggest banks is shown to improve the stability of the system in the regime of high average degree. Finally, disassortative mixing, such as that observed in real banking networks, is shown to enhance the stability of the system.

Keywords: Network Models, Systemic Risk

Suggested Citation

Caccioli, Fabio and Catanach, Thomas A. and Farmer, J. Doyne, Heterogeneity, Correlations and Financial Contagion (September 6, 2011). Available at SSRN: https://ssrn.com/abstract=1923246 or http://dx.doi.org/10.2139/ssrn.1923246

Fabio Caccioli (Contact Author)

University College London - Financial Computing and Analytics Group, Department of Computer Science ( email )

Gower Street
London, WC1E 6BT
United Kingdom

Thomas A. Catanach

University of Notre Dame ( email )

361 Mendoza College of Business
Notre Dame, IN New South Wales 46556-5646
United States

J. Doyne Farmer

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School ( email )

Eagle House
Walton Well Road
Oxford, OX2 6ED
United Kingdom

HOME PAGE: http://www.inet.ox.ac.uk/people/view/4

Santa Fe Institute ( email )

1399 Hyde Park Road
Santa Fe, NM 87501
United States
505-984-8800 (Phone)
505-982-0565 (Fax)

HOME PAGE: http://www.santafe.edu/~jdf/

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