Risk-sharing and contagion in networks

1. Cabrales Goitia, Antonio
2. Gottardi, Piero
3. Vega-Redondo, Fernando

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We investigate the trade-off, arising in financial networks, between higher risk-sharing and greater exposure to contagion when the connectivity increases. We find that with shock distributions displaying �fat� tails, extreme segmentation into small components is optimal, while minimal segmentation and high density of connections are optimal with distributions exhibiting �thin� tails. For less regular distributions, intermediate degrees of segmentation and sparser connections are optimal. If firms are heterogeneous, optimality requires perfect assortativity in their linkages. In gen- eral, however, a conflict arises between optimality and individual incentives to establish linkages, due to a �size externality� not internalized by firms.

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