Systemic Risk and Stability in Financial Networks

47 Pages Posted: 26 Jan 2013

See all articles by Daron Acemoglu

Daron Acemoglu

Massachusetts Institute of Technology (MIT) - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Asuman E. Ozdaglar

Massachusetts Institute of Technology (MIT) - Department of Electrical Engineering and Computer Science

Alireza Tahbaz-Salehi

Northwestern University - Kellogg School of Management

Multiple version iconThere are 4 versions of this paper

Date Written: January 2013

Abstract

We provide a framework for studying the relationship between the financial network architecture and the likelihood of systemic failures due to contagion of counterparty risk. We show that financial contagion exhibits a form of phase transition as interbank connections increase: as long as the magnitude and the number of negative shocks affecting financial institutions are sufficiently small, more "complete" interbank claims enhance the stability of the system. However, beyond a certain point, such interconnections start to serve as a mechanism for propagation of shocks and lead to a more fragile financial system. We also show that, under natural contracting assumptions, financial networks that emerge in equilibrium may be socially inefficient due to the presence of a network externality: even though banks take the effects of their lending, risk-taking and failure on their immediate creditors into account, they do not internalize the consequences of their actions on the rest of the network.

Suggested Citation

Acemoglu, Daron and Ozdaglar, Asuman E. and Tahbaz-Salehi, Alireza, Systemic Risk and Stability in Financial Networks (January 2013). NBER Working Paper No. w18727. Available at SSRN: https://ssrn.com/abstract=2207263

Daron Acemoglu (Contact Author)

Massachusetts Institute of Technology (MIT) - Department of Economics ( email )

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Centre for Economic Policy Research (CEPR)

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National Bureau of Economic Research (NBER)

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Asuman E. Ozdaglar

Massachusetts Institute of Technology (MIT) - Department of Electrical Engineering and Computer Science ( email )

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Alireza Tahbaz-Salehi

Northwestern University - Kellogg School of Management ( email )

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Evanston, IL 60208
United States

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