What Makes Financial Networks Special? Distorted Investment Incentives, Regulation, and Systemic Risk Measurement

54 Pages Posted: 18 Jan 2019 Last revised: 7 May 2019

See all articles by Matthew O. Jackson

Matthew O. Jackson

Stanford University - Department of Economics; Santa Fe Institute; Canadian Institute for Advanced Research (CIFAR)

Agathe Pernoud

Stanford University - Department of Economics

Date Written: March 1, 2019

Abstract

We provide an overview of some key trends and features of financial networks related to systemic risk. We also provide a new network model of inter-dependencies, and use this to analyze the incentives that financial institutions have to choose the risk in their portfolios, their trading partners, and the correlation of their portfolios with those direct and indirect counterparties. We show that they have incentives to choose excessively risky portfolios, and to under-diversify in terms of choosing too few counterparties with whom to share risks. We also show that banks have strong incentives to perfectly correlate the situations in which their portfolios perform poorly, which generally increases systemic risk. We then provide a measure of financial centrality in terms of the consequences of a given institution's portfolio on the potential defaults of other institutions. We discuss minimum interventions or capital needed to ensure systemic solvency.


Keywords: Financial Networks, Markets, Systemic Risk, Financial Crises, Correlated Portfolios, Default Risk, Networks, Banks

JEL Classification: D85, F15, F34, F36, F65, G15, G32, G33, G38

Suggested Citation

Jackson, Matthew O. and Pernoud, Agathe, What Makes Financial Networks Special? Distorted Investment Incentives, Regulation, and Systemic Risk Measurement (March 1, 2019). Available at SSRN: https://ssrn.com/abstract=3311839 or http://dx.doi.org/10.2139/ssrn.3311839

Matthew O. Jackson (Contact Author)

Stanford University - Department of Economics ( email )

Landau Economics Building
579 Serra Mall
Stanford, CA 94305-6072
United States
1-650-723-3544 (Phone)

HOME PAGE: http://www.stanford.edu/~jacksonm

Santa Fe Institute

1399 Hyde Park Road
Santa Fe, NM 87501
United States

Canadian Institute for Advanced Research (CIFAR) ( email )

180 Dundas Street West, Suite 1400
Toronto, Ontario
Canada

Agathe Pernoud

Stanford University - Department of Economics ( email )

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

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