Distress Dispersion and Systemic Risk in Networks

Abstract

I develop a model of contagion that stems from endogenous risk-sharing when financial firms differ in distress levels. Firms face costly liquidation and strategically trade assets, thereby forming links. A link with a distressed firm can be socially costly as it raises system-wide liquidation risk. When firms are highly dispersed in financial distress, the network composition is distorted in two ways: it features too many links with distressed firms and too few risk-sharing links among non-distressed firms. This inefficiency arises from an externality when bilateral trading terms are not contingent on links faraway in the network. Using insights from the model, I discuss policy implications for financial stability. I also show empirical evidence that the distress dispersion across financial firms provides a novel indicator for systemic risk.

Keywords: Financial network formation, systemic risk, financial distress, network externality.

JEL Classification: D85, G01, G20, G28