Investment Incentives and Regulation in Financial Networks
45 Pages Posted: 18 Jan 2019 Last revised: 3 Aug 2021
Date Written: March 1, 2019
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 differs as a function of an organization's financial centrality and its available investment opportunities. We discover that optimal regulation depends non-monotonically on the correlation of banks' investments, with maximal restrictions for intermediate levels of correlation. Moreover, in standard core-periphery networks it can be uniquely optimal to treat banks asymmetrically: restricting the investments of one core bank while allowing an otherwise identical core bank (in all aspects, including in network centrality) to invest freely.
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: Suggested Citation