Financial Networks and Contagion

Abstract

Globalization brings with it increased financial interdependencies among many kinds of organizations-governments, central banks, investment banks, firms, etc.-that hold each other's shares, debts, and other obligations. Such interdependencies can lead to cascading defaults and failures, which are often avoided through massive bailouts of institutions deemed "too big to fail." Recent examples include the US government's interventions in AIG, Fannie Mae, Freddie Mac, and General Motors; and the European Commission's interventions in Greece and Spain. Although such bailouts circumvent the widespread failures that were more prevalent in the nineteenth and early twentieth centuries, they emphasize the need to study the risks created by a network of interdependencies. Understanding these risks is crucial to designing incentives and regulatory responses which defuse cascades before they are imminent.In this paper we develop a general model that produces new insights regarding financial contagions and cascades of failures among organizations linked through a network of financial interdependencies. Organizations' values depend on each other-e.g., through cross-holdings of shares, debt, or other liabilities. If an

The joint impact of bankruptcy costs, fire sales and cross-holdings on systemic risk in financial networks

“…We use a simulation procedure similar to Elliott et al (2014). Specifically, we choose two parameters c ∈ [0, 1] and d ∈ [0, n − 1] describing the level of integration and diversification of the relative liabilities network.…”

“…It is well-known that cross-holdings inflate the value of the financial system, see Brioschi et al (1989), Fedenia et al (1994, and Elliott et al (2014). This, in particular, refers to the fact that the aggregated net worth of all banks will be larger than the value of total assets if cross-holdings are present.…”

“…This, in particular, refers to the fact that the aggregated net worth of all banks will be larger than the value of total assets if cross-holdings are present. As argued in Brioschi et al (1989), Fedenia et al (1994, and Elliott et al (2014), net worths need to be adjusted by an auxiliary factor that guarantees the conservation of value in the system. The market value of bank i should thus be computed as (1 − j∈N C i j )w i for w i ≥ 0.…”

“…As mentioned before, due to cross-holdings, the net worths of the banks differ from their market values, see Brioschi et al (1989), Fedenia et al (1994, and Elliott et al (2014). We will, however, focus on default count statistics which can be computed in terms of the vector of net worths.…”

“…While we investigate their joint impact, up to now the literature has only been studying these factors separately: Bankruptcy costs are, for example, considered by Elsinger (2009), Elliott et al (2014), Rogers and Veraart (2013), and Glasserman and Young (2015); cross-holdings, e.g., by Elsinger (2009), Elliott et al (2014), Fischer (2014), Suzuki (2002), and Karl and Fischer (2014). Cifuentes et al (2005) incorporate fire sales into the setting of Eisenberg and Noe (2001); their approach is further extended by Amini et al (2013), Chen et al (2016), Gai and Kapadia (2010), Nier et al (2007), and Feinstein (2017).…”