Optimal Fragile Financial Networks

Abstract

We study a financial network characterized by the presence of depositors, banks and their shareholders. Belonging to a financial network is beneficial for both the depositors and banks' shareholders since the return to investment increases with the number of banks connected. However, the network is fragile since banks, which invest on behalf of the depositors, can gamble with depositors' money (making an investment that is dominated in expected terms) when not sufficiently capitalized. The bankruptcy of a bank negatively affects the banks connected to it in the network. First, we compute the social planner solution and the efficient financial network is characterized by a core-periphery structure. Second, we analyze the decentralized solution showing under which conditions participating in a fragile financial network is ex-ante optimal. In particular, we show that this is optimal when the probability of bankruptcy is sufficiently low giving rationale of financial fragility as a rare phenomenon. Finally, we analyze the efficiency of the decentralized financial network. Again, if the probability of bankruptcy is sufficiently low the structure of the decentralized financial network is equal to the e¢ cient one, yielding an ex- pected payo¤ arbitrarily close to the efficient one. However, the investment decision is not the same. That is, in the decentralized network some banks will gamble as compared to the socially preferred outcome.