Distorted Investment Incentives, Regulation, and Equilibrium Multiplicity in a Model of Financial Networks

67 Pages Posted: 18 Jan 2019 Last revised: 22 May 2020

See all articles by Matthew O. Jackson

Matthew O. Jackson

Stanford University - Department of Economics; Santa Fe Institute

Agathe Pernoud

Stanford University - Department of Economics

Date Written: March 1, 2019

Abstract

In a model of financial networks that admits both debt and equity interdependencies, we show that financial organizations have incentives to choose excessively risky portfolios, and overly correlate their portfolios with those of their counterparties. We show how optimal regulation depends on specific measures of financial centrality that capture how a given organization's portfolio affects the values and defaults of other organizations. Additionally, we provide a comprehensive analysis of the multiplicity of equilibrium values for banks, which increases the fragility of the financial network. Multiplicity arises if and only if there exists a certain type of dependency cycle in the network and that those cycles admit self-fulfilling default cascades. We fully characterize the minimum bailouts needed to ensure systemic solvency. We show that the bailouts needed to eliminate self-fulfilling cycles of defaults are fully recoverable, while those needed to prevent cascading defaults in the best equilibrium are not.

Keywords: Financial Networks, Markets, Systemic Risk, Financial Crises, Correlated Portfolios, Default Risk, Networks, Banks

JEL Classification: D85, F15, F34, F36, F65, G15, G32, G33, G38

Suggested Citation

Jackson, Matthew O. and Pernoud, Agathe, Distorted Investment Incentives, Regulation, and Equilibrium Multiplicity in a Model of Financial Networks (March 1, 2019). Available at SSRN: https://ssrn.com/abstract=3311839 or http://dx.doi.org/10.2139/ssrn.3311839

Matthew O. Jackson (Contact Author)

Stanford University - Department of Economics ( email )

Landau Economics Building
579 Serra Mall
Stanford, CA 94305-6072
United States
1-650-723-3544 (Phone)

HOME PAGE: http://www.stanford.edu/~jacksonm

Santa Fe Institute

1399 Hyde Park Road
Santa Fe, NM 87501
United States

Agathe Pernoud

Stanford University - Department of Economics ( email )

Landau Economics Building
579 Serra Mall
STANFORD, CA 94305-6072
United States

HOME PAGE: http://web.stanford.edu/~agathep

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