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Paper: ETH-RC-11-006

Title: Default Cascades: When Does Risk Diversification Increase Stability?

Authors: Stefano Battiston*, Domenico Delli Gatti, Mauro Gallegati, Bruce Greenwald, Joseph E. Stiglitz


We explore the dynamics of default cascades in a network of credit interlinkages in which each agent is at the same time a borrower and a lender. When some counterparties of an agent default, the loss she experiences amounts to her total exposure to those counterparties. A possible conjecture in this context is that individual risk diversification across more numerous counterparties should make also systemic defaults less likely. We show that this view is not always true. In particular, the diversification of credit risk across many borrowers has ambiguous effects on systemic risk in the presence of mechanisms of loss amplifications such as in the presence of potential runs among the short-term lenders of the agents in the network.

Keywords: Systemic risk, Network models, Contagion, Financial acceleration, Financial crises

Manuscript status: Submitted

JEL codes: D85, G01, G21
PACS numbers:

Local copy of the paper: ETH-RC-11-006.pdf

Submission date: 19-9-2011

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