Stability Analysis of Financial Contagion Due to Overlapping Portfolios

25 Pages Posted: 16 Nov 2012

See all articles by Fabio Caccioli

Fabio Caccioli

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

Munik Shrestha

Santa Fe Institute; University of New Mexico

Cristopher Moore

Santa Fe Institute

J. Doyne Farmer

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

Date Written: November 15, 2012

Abstract

Common asset holdings are widely believed to have been the primary vector of contagion in the recent financial crisis. We develop a network approach to the amplification of financial contagion due to the combination of overlapping portfolios and leverage, and we show how it can be understood in terms of a generalized branching process. By studying a stylized model we estimate the circumstances under which systemic instabilities are likely to occur as a function of parameters such as leverage, market crowding, diversification, and market impact. Although diversification may be good for individual institutions, it can create dangerous systemic effects, and as a result financial contagion gets worse with too much diversification. Under our model there is a critical threshold for leverage; below it financial networks are always stable, and above it the unstable region grows as leverage increases. The financial system exhibits 'robust yet fragile' behavior, with regions of the parameter space where contagion is rare but catastrophic whenever it occurs. Our model and methods of analysis can be calibrated to real data and provide simple yet powerful tools for macro-prudential stress testing.

Keywords: network models, systemic risk

Suggested Citation

Caccioli, Fabio and Shrestha, Munik and Moore, Cristopher and Farmer, J. Doyne, Stability Analysis of Financial Contagion Due to Overlapping Portfolios (November 15, 2012). Available at SSRN: https://ssrn.com/abstract=2176080 or http://dx.doi.org/10.2139/ssrn.2176080

Fabio Caccioli (Contact Author)

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

Gower Street
London, WC1E 6BT
United Kingdom

Munik Shrestha

Santa Fe Institute ( email )

1399 Hyde Park Road
Santa Fe, NM 87501
United States

University of New Mexico ( email )

107 Humanitites Building
Albuquerque, NM 87131-1221
United States

Cristopher Moore

Santa Fe Institute ( email )

1399 Hyde Park Road
Santa Fe, NM 87501
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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