Default Cascades: When Does Risk Diversification Increase Stability?

ETH Risk Center Working Paper No. 11-006

30 Pages Posted: 21 Dec 2012

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: September 19, 2011

Abstract

We explore the dynamics of default cascades in a network of credit interlinkages in which each agent is at the same time a borrower and a lender. When some counterparties of an agent default, the loss she experiences amounts to her total exposure to those counterparties. A possible conjecture in this context is that individual risk diversification across more numerous counterparties should make also systemic defaults less likely. We show that this view is not always true. In particular, the diversification of credit risk across many borrowers has ambiguous effects on systemic risk in the presence of mechanisms of loss amplifications such as in the presence of potential runs among the short-term lenders of the agents in the network.

Keywords: Systemic risk, Network models, Contagion, Financial acceleration, Financial crises

JEL Classification: D85, G01, G21

Suggested Citation

Battiston, Stefano and Delli Gatti, Domenico and Gallegati, Mauro and Greenwald, Bruce and Stiglitz, Joseph E., Default Cascades: When Does Risk Diversification Increase Stability? (September 19, 2011). ETH Risk Center Working Paper No. 11-006. Available at SSRN: https://ssrn.com/abstract=2191532 or http://dx.doi.org/10.2139/ssrn.2191532

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

Register to save articles to
your library

Register

Paper statistics

Downloads
70
Abstract Views
728
rank
336,901
PlumX Metrics