Stability analysis of financial contagion due to overlapping portfolios

TL;DR

This paper models how overlapping portfolios and leverage can amplify financial contagion, revealing critical thresholds and systemic risks, and offers tools for stress testing based on network analysis.

Contribution

It introduces a network-based model of financial contagion considering overlapping portfolios and leverage, highlighting systemic risks and stability thresholds.

Findings

Diversification can increase systemic risk under certain conditions.

A critical leverage threshold determines stability or instability.

Financial system shows 'robust yet fragile' behavior.

Abstract

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. 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. Under our model there is a critical threshold for leverage; below it financial networks are always stable, and above it the unstable region grows as leverage increases. 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.