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Liaisons Dangereuses: Increasing Connectivity, Risk Sharing, and Systemic Risk

Working Paper #241

Joseph Stiglitz, Mauro Gallegati, Stefano Battiston, Domenico Delli Gatti, Bruce Greenwald

Paper  432kb pdf

We characterize the evolution over time of a network of credit relations among financial agents as a system of coupled stochastic processes. Each process describes the dynamics of individual financial robustness, while the coupling results from a network of liabilities among agents. The average level of risk diversification of the agents coincides with the density of links in the network. In addition to a process of diffusion of financial distress, we also consider a discrete process of default cascade, due to the re-evaluation of agents assets. In this framework we investigate the probability of individual defaults as well as the probability of systemic default as a function of the network density. While it is usually thought that diversification of risk always leads to a more stable financial system, in our model a tension emerges between individual risk and systemic risk. As the number of counterparties in the credit network increases beyond a certain value, the default probability, both individual and systemic, starts to increase. This tension originates from the fact that agents are subject to a financial accelerator mechanism. In other words, individual financial fragility feeding back on itself may amplify the effect of an initial shock and lead to a full fledged systemic crisis. The results offer a simple possible explanation for the endogenous emergence of systemic risk in a credit network.

About the Authors

Joseph Stiglitz
Co-President
Initiative for Policy Dialogue (IPD)

Joseph E. Stiglitz is co-President of the Initiative for Policy Dialogue, and Chairman of the Committee on Global Thought at Columbia University. He is University Professor at Columbia, teaching in its Economics Department, its Business School, and its School of International and Public Affairs. He chaired the UN Commission of Experts on Reforms of the International Monetary and Financial System, created in the aftermath of the financial crisis by the President of the General Assembly. He is former Chief Economist and Senior Vice-President of the World Bank and Chairman of President Clinton’s Council of Economic Advisors. He was awarded the Nobel Memorial Prize in Economics in 2001.

Mauro Gallegati
Professor
Economics Department
Universita' Politecnica delle Marche

Stefano Battiston
Chair of Systems Design, Department of Management, Technology, and Economics
ETH Zurich

Domenico Delli Gatti
Professor
Catholic University of the Sacred Heart

Bruce Greenwald
Professor
Columbia University Graduate School of Business

Publication Information

Type Working Paper
Program Financial Markets Reform
Posted 11/25/09
Download 432kb pdf
# Pages 28