Topic: Endogenous Financial Networks: Efficient Modularity and Why Shareholders Prevent It (joint work with Jonathon Hazell)
We consider systemic risk in financial networks, by examining the conflict of interest between debt- and equity-holders. Through trading, banks can diversify their idiosyncratic risks and avoid failures following small shocks. However, the resulting interdependencies can cause multiple failures after large shocks. A social planner resolves this trade-off by creating a modular network structure with fire breaks, thereby preventing failures from small shocks while containing contagion. Socially efficient networks favor debt-holders over equity holders, meaning equity-holders can profitably trade away from these networks. Moreover, profitable trades for equity holders align their counter-parties’ failures with their own, creating systemic risk.
The full paper is at: http://www.its.caltech.edu/~melliott/papers/Financial_Networks_Efficienc...