Distress Dispersion and Systemic Risk in Networks

62 Pages Posted: 4 Apr 2015 Last revised: 6 Apr 2021

See all articles by Jessie Jiaxu Wang

Jessie Jiaxu Wang

Arizona State University (ASU) - W.P. Carey School of Business; Board of Governors of the Federal Reserve System

Date Written: December 1, 2015

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

Suggested Citation

Wang, Jessie Jiaxu, Distress Dispersion and Systemic Risk in Networks (December 1, 2015). Available at SSRN: https://ssrn.com/abstract=2588910 or http://dx.doi.org/10.2139/ssrn.2588910

Jessie Jiaxu Wang (Contact Author)

Arizona State University (ASU) - W.P. Carey School of Business ( email )

Tempe, AZ 85287-3706
United States

HOME PAGE: http://www.jiaxuwang.com

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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