Financial Networks and Contagion
Social Science Research Network
We model contagions and cascades of failures among organizations linked through a network of financial interdependencies. We identify how the network propagates discontinuous changes in asset values triggered by failures (e.g., bankruptcies, defaults, and other insolvencies) and use that to study the consequences of integration (each organization becoming more dependent on its counterparties) and diversification (each organization interacting with a larger number of counterparties). Integration
... rties). Integration and diversification have different, nonmonotonic effects on the extent of cascades. Initial increases in diversification connect the network which permits cascades to propagate further, but eventually, more diversification makes contagion between any pair of organizations less likely as they become less dependent on each other. Integration also faces tradeoffs: increased dependence on other organizations versus less sensitivity to own investments. We explore some strategic implications: failing organizations can only be saved by unfair trades, and moral hazard issues arise from incentives to seek such bailouts. Finally, we illustrate some aspects of the model with data on European debt cross-holdings.