Contagion and Stability in Financial Networks

Abstract: This paper investigates two mechanisms of financial contagion that are, firstly, the correlated exposure of banks to the same source of risk, and secondly the direct exposure of banks in the interbank market. It will consider a random network of banks which are connected through the inter-bank market and will discuss the desirable level of banks exposure to the same sources of risk, that is investment in similar portfolios, for different levels of network connectivity when peering through the lens of the systemic cost incurred to the economy from the banks simultaneous failure. It demonstrates that for all levels of network connectivity, certain levels of diversifying individual banks diversifications are not optimum under any condition. So, given an acceptable level of systemic cost, the regulator could let banks decrease their capital buffers by moving away from the non-optimum area.