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The effect of heterogeneity on financial contagion due to overlapping portfolios

Banwo, Opeoluwa and Caccioli, Fabio and Harrald, Paul and Medda, Francesca (2017) The effect of heterogeneity on financial contagion due to overlapping portfolios. Advances in Complex Systems, 19 (8). ISSN 0219-5259

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Identification Number: 10.1142/S0219525916500168

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.

Item Type: Article
Official URL: http://www.worldscientific.com/worldscinet/acs
Additional Information: © 2017 World Scientific Publishing Company
Subjects: H Social Sciences > HG Finance
Q Science > QA Mathematics > QA75 Electronic computers. Computer science
Sets: Research centres and groups > Systemic Risk Centre
Date Deposited: 07 Mar 2017 09:21
Last Modified: 22 Sep 2017 11:21
URI: http://eprints.lse.ac.uk/id/eprint/69678

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