The effect of heterogeneity on financial contagion due to overlapping portfolios

Opeoluwa Banwo, Fabio Caccioli, Paul Harrald and Francesca Medda

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: We consider a model of financial contagion in a bipartite network of assets and banks recently introduced in the literature, and we study the effect of power law distributions of degree and balance-sheet size on the stability of the system. Relative to the benchmark case of banks with homogeneous degrees and balance-sheet sizes, we find that if banks have a power law degree distribution the system becomes less robust with respect to the initial failure of a random bank, and that targeted shocks to the most specialized banks (i.e., banks with low degrees) or biggest banks increases the probability of observing a cascade of defaults. In contrast, we find that a power law degree distribution for assets increases stability with respect to random shocks, but not with respect to targeted shocks. We also study how allocations of capital buffers between banks affects the system’s stability, and we find that assigning capital to banks in relation to their level of diversification reduces the probability of observing cascades of defaults relative to size-based allocations. Finally, we propose a non-capital-based policy that improves the resilience of the system by introducing disassortative mixing between banks and assets.

Keywords: Contagion; systemic risk; network models (search for similar items in EconPapers)
JEL-codes: F3 G3 (search for similar items in EconPapers)
Date: 2017-02-10
New Economics Papers: this item is included in nep-ban
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

Published in Advances in Complex Systems, 10, February, 2017, 19(8). ISSN: 0219-5259

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Related works:
Working Paper: The effect of heterogeneity on financial contagion due to overlapping portfolios (2017)
Journal Article: THE EFFECT OF HETEROGENEITY ON FINANCIAL CONTAGION DUE TO OVERLAPPING PORTFOLIOS (2016)
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Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:69678

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