Joint with B. Golub and M. Jackson
We model financial contagions and cascades of defaults among organizations that have a network of cross holdings. We first identify a network-based measure that captures the impact of changes in one organization's value on other organizations' values. We use the measure to study both integration (the increasing of cross holdings) and diversification (the spreading out of cross holdings). We show that diversification initially increases the probability and extent of cascades as a network of interdependencies grows, and eventually the probability and extent of cascades decreases once organizations become less tied to specific other organizations. Integration also faces tradeoffs: increased dependence on other organizations versus less sensitivity to own investments. We briefly discuss incentives to seek bailouts, and associated moral-hazard issues. We also show that once an organization approaches a bankruptcy threshold, there are no trades of cross holdings or assets at fair prices that can lower the probability of its failure, and that unduly favorable trades for that organization and/or a direct injection of capital are necessitated. Finally, we illustrate some aspects of the model with European debt cross holdings.
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