Financial Centrality and Liquidity Provision

51 Pages Posted: 20 Mar 2018

See all articles by Arun G. Chandrasekhar

Arun G. Chandrasekhar

Stanford University - Department of Economics

Robert M. Townsend

Massachusetts Institute of Technology (MIT)

Juan Pablo Xandri

Princeton University

Date Written: March 2018

Abstract

We study an endowment economy in which agents face income risk, as if uncertain returns on a portfolio, and agents can only make transfers in states when they are actively participating in the market. Besides income risk, agents also have limited and stochastic market access, with a probability distribution governed by an underlying social network. While network connections may serve to dissipate shocks, they may also provide obstacles to the sharing of risk, as when participation frictions are generated through the network. We identify and quantify the value of key players in terms of whether they are likely to be able to smooth the resulting market participation risk and how valuable that smoothing would be when they are there. We define financial centrality in economic terms, given the model, as the ex ante marginal social value of injecting an infinitesimal amount of liquidity to the agent. We show that the most financially central agents are not only those who trade often – as in standard network models – but are more likely to trade when there are few traders, when income risk is high, when income shocks are positively correlated, when attitudes toward risk are more sensitive in the aggregate, when there are distressed institutions, and when there are tail risks. We extend our framework to allow for endogenous market participation. Observational evidence from village risk sharing network data is consistent with our model.

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Suggested Citation

Chandrasekhar, Arun G. and Townsend, Robert M. and Xandri, Juan Pablo, Financial Centrality and Liquidity Provision (March 2018). NBER Working Paper No. w24406. Available at SSRN: https://ssrn.com/abstract=3143311

Arun G. Chandrasekhar (Contact Author)

Stanford University - Department of Economics ( email )

Landau Economics Building
579 Serra Mall
Stanford, CA 94305-6072
United States

Robert M. Townsend

Massachusetts Institute of Technology (MIT) ( email )

77 Massachusetts Avenue
50 Memorial Drive
Cambridge, MA 02139-4307
United States

Juan Pablo Xandri

Princeton University ( email )

22 Chambers Street
Princeton, NJ 08544-0708
United States

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