What Makes Financial Networks Special? Distorted Investment Incentives, Regulation, and Systemic Risk Measurement

In a model of financial networks with both debt and equity interdependencies, we show that financial organizations have incentives to: choose excessively risky portfolios; overly correlate their portfolios with those of their counterparties; and under-diversify in terms of choosing too few counterparties with whom to share risk. We also provide measures of financial centrality in terms of how a given organization’s portfolio affects the values and defaults of other organizations. Additionally, we characterize optimal regulation in terms of the use of reserve requirements versus bailouts and how these relate to financial centrality, and fully characterize the minimum bailouts needed to ensure systemic solvency. JEL Classification Codes: D85, F15, F34, F36, F65, G15, G32, G33, G38

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