Stability analysis of financial contagion due to overlapping portfolios
By Fabio Caccioli, Munik Shrestha, Cristopher Moore, J. D. Farmer. arXiv.org, 2012
401 citations recorded by the source corpus.
Common asset holdings are widely believed to have been the primary vector of contagion in the recent financial crisis. We develop a network approach to the amplification of financial contagion due to the combination of overlapping portfolios and leverage, and we show how it can be understood in terms of a generalized branching process. This can be used to compute the stability for any particular configuration of portfolios. By studying a stylized model we estimate the circumstances under which systemic instabilities are likely to occur as a function of parameters such as leverage, market crowding, diversification, and market impact. Although diversification may be good for individual institutions, it can create dangerous systemic effects, and as a result financial contagion gets worse with too much diversification. There is a critical threshold for leverage; below it financial networks are always stable, and above it the unstable region grows as leverage increases. Note that our model assumes passive portfolio management during a crisis; however, we show that dynamic deleveraging during a crisis can amplify instabilities. The financial system exhibits “robust yet fragile” behavior, with regions of the parameter space where contagion is rare but catastrophic whenever it occurs. Our model and methods of analysis can be calibrated to real data and provide simple yet powerful tools for macroprudential stress testing.
Subfields: Economics and Econometrics, Finance
View Paper: https://www.semanticscholar.org/paper/0a89833095c81b682e2345e9a205fdf6a1465641
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Citations in the corpus
- Too Interconnected to Fail: A Survey of the Interbank Networks Literature (2015, background): “(Caccioli et al., 2014) and linked portfolio returns (Lagunoff and Schreft, 2001).”
- Fire sales, indirect contagion and systemic stress testing (2017, neutral): “Fire sales generate endogenous risk [Shin, 2010] and can also act as channel of loss contagion across asset classes and across financial institutions holding these assets [Khandani and Lo, 2011, Cont and Wagalath, 2016, Caccioli et al., 2014].”