Report

Heterogeneity and stability: bolster the strong, not the weak

Abstract: This paper provides a model of systemic panic among financial institutions with heterogeneous fragilities. Concerns about potential spillovers from each other generate strategic interaction among institutions, triggering a preemption game in which one tries to exit the market before the others to avoid spillovers. Although financial contagion originates in weaker institutions, systemic risk depends critically on the financial health of stronger institutions in the contagion chain. This analysis suggests that when concerns about spillovers prevail, then 1) increasing heterogeneity of institutions promotes systemic stability and 2) bolstering the strong institutions in the contagion chain, rather than the weak, more effectively enhances systemic stability.

Keywords: panic; financial spillovers; financial crises;

JEL Classification: G01; G00;

Bibliographic Information

Provider: Federal Reserve Bank of New York

Part of Series: Staff Reports

Publication Date: 2013-09-01

Number: 637

Pages: 53 pages

Note: For a published version of this report, see Dong Beom Choi, "Heterogeneity and Stability: Bolster the Strong, Not the Weak," Review of Financial Studies 27, no. 6 (May 2014): 1830-67.