Section: New Results
Participants : Agnès Bialobroda Sulem, Andreea Minca [Cornell University)] , Rui Chen.
Our objective is to study the magnitude of default contagion in a large financial system, in which banks receive benefits from their connections, and to investigate how the institutions choose their connectivities by weighing the default risk and the benefits induced by connectivity. We study two versions of the model. In the first version (static) the benefits are received at the end of the contagion. In this case, each bank either receives fixed benefits per link if it survives, otherwise its payoff is zero. In the second version, which is a dynamic model, banks receive cash-flows from their connections, spread over time. Effectively, these cash flows increase the threshold of the bank over the time of contagion. We call this model contagion with intrinsic recovery features. In the first model, there is no calendar time. In the second model, the cash flows arrive at a certain rate in calendar time, while the losses come with each revealed link. We thus need to relate the intensity of revealing a link with calendar time. Both models have new features compared to past literature. The most important feature is that banks choose their connectivities optimally. The second model is dynamic and introduces growth over time. Computing the magnitude of contagion in this case is challenging, and we provide an iterative solution for this.