Systemic Risk and Stability in Financial Networks", NBER Working Paper No. 18727 (2013) [2

This paper argues that the extent of financial contagion exhibits a form of phase transition: as long as the magnitude of negative shocks affecting financial institutions are sufficiently small, a more densely connected financial network (corresponding to a more diversified pattern of interbank liabilities) enhances financial stability. However, beyond a certain point, dense interconnections serve as a mechanism for the propagation of shocks, leading to a more fragile financial system. Our results thus highlight that the same factors that contribute to resilience under certain conditions may function as significant sources of systemic risk under others. (JEL D85, E44, G21, G28, L14) Since the global financial crisis of 2008, the view that the architecture of the financial system plays a central role in shaping systemic risk has become conven-tional wisdom. The intertwined nature of the financial markets has not only been proffered as an explanation for the spread of risk throughout the system (see, e.g.