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The effect of heterogeneity on financial contagion due to overlapping portfolios

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  • Banwo, Opeoluwa
  • Caccioli, Fabio
  • Harrald, Paul
  • Medda, Francesca
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.

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  • Banwo, Opeoluwa & Caccioli, Fabio & Harrald, Paul & Medda, Francesca, 2017. "The effect of heterogeneity on financial contagion due to overlapping portfolios," LSE Research Online Documents on Economics 69678, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:69678
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    References listed on IDEAS

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    Cited by:

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    2. Gupta, Aparna & Wang, Runzu & Lu, Yueliang, 2021. "Addressing systemic risk using contingent convertible debt – A network analysis," European Journal of Operational Research, Elsevier, vol. 290(1), pages 263-277.
    3. Ramadiah, Amanah & Caccioli, Fabio & Fricke, Daniel, 2020. "Reconstructing and stress testing credit networks," Journal of Economic Dynamics and Control, Elsevier, vol. 111(C).
    4. V. Sasidevan & Nils Bertschinger, 2019. "Systemic Risk: Fire-Walling Financial Systems Using Network-Based Approaches," Papers 1912.05273, arXiv.org.
    5. X. Zhang & L. D. Valdez & H. E. Stanley & L. A. Braunstein, 2019. "Modeling Risk Contagion in the Venture Capital Market: A Multilayer Network Approach," Complexity, Hindawi, vol. 2019, pages 1-11, December.

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    More about this item

    Keywords

    Contagion; systemic risk; network models;
    All these keywords.

    JEL classification:

    • F3 - International Economics - - International Finance
    • G3 - Financial Economics - - Corporate Finance and Governance

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