Systemic Risk and Stability in Financial Networks

50 Pages Posted: 26 Jan 2013 Last revised: 4 Feb 2015

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: August 30, 2014

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.

Keywords: contagion, counterparty risk, financial network, systemic risk

JEL Classification: G01, D85

Suggested Citation

Acemoglu, Daron and Ozdaglar, Asuman E. and Tahbaz-Salehi, Alireza, Systemic Risk and Stability in Financial Networks (August 30, 2014). American Economic Review, 105(2): 564-608, 2015; Columbia Business School Research Paper No. 13-4. Available at SSRN: https://ssrn.com/abstract=2207439 or http://dx.doi.org/10.2139/ssrn.2207439

Daron Acemoglu

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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United States
617-324-0058 (Phone)

Alireza Tahbaz-Salehi (Contact Author)

Northwestern University - Kellogg School of Management ( email )

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Evanston, IL 60208
United States

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