Working Paper

Financial networks: contagion, commitment, and private sector bailouts

Abstract: The author develops a model of financial networks where linkages not only spread contagion, but also induce private-sector bailouts in which liquid banks bail out illiquid banks because of the threat of contagion. Introducing this bailout possibility, the author shows that linkages may be optimal ex-ante because they allow banks to obtain some mutual insurance even though formal commitments are impossible. However, in some cases (for example, when liquidity is concentrated among a small group of banks), the whole network may collapse. The author also characterizes the optimal network size and apply the results to joint liability arrangements and payment systems.> Original working paper title: Fragile financial networks.

Keywords: Financial markets;

Status: Published in Journal of Finance, 60, no. 6 (December, 2005) : 2925-2953

Bibliographic Information

Provider: Federal Reserve Bank of Philadelphia

Part of Series: Working Papers

Publication Date: 2004

Number: 02-9