Cambridge Finance Workshop Series are usually held on Thursdays during term time. The workshops are an opportunity for those working in finance to present their latest results or papers.
Matthew Elliott, University Lecturer, Faculty of Economics, University of Cambridge.
Firebreaks and Risk-Shifting in Financial Networks
Matthew Elliott and Jonathon Hazell
May 2017, first draft September 2015
Abstract
Financial connections hedge risks, but also propagate large shocks. We characterise socially optimal financial networks in the presence of this tradeoff. These networks divide banks into groups, with strong connections within groups but weak connections between groups. The weak connections
create firebreaks, which limit the spread of contagion. When financial distress costs are below a certain threshold, socially efficient networks cannot form in equilibrium. Shareholders engage in risk-shifting by altering financial connections—thereby increasing equity value, but also raising the likelihood of contagion. Equally, socially efficient networks are an equilibrium when financial distress costs are above this threshold. Contagion becomes so costly that banks are not willing to take the other side of a risk-shifting trade.