Contagion in Financial Networks

A the many factors contributing to the financial crisis of 2007–08, the role of the growing interconnectedness of the global financial system is perhaps the least understood. The crisis exposed the fact that regulators and market participants had very limited information about the network of obligations between financial institutions. It also revealed that there was little theoretical understanding of the relationship between interconnectedness and financial stability. Since that time there has been an upsurge in empirical and theoretical work on these issues. The aim of this article is to survey this literature, with the focus on what it tells us about the relationship between network structure and the vulnerability of the financial system to contagion. The key challenges facing this research area include the following: What are the reasons for the growing interconnectedness of the financial system? Do more connections tend to amplify or dampen systemic shocks? Does the structure of the network matter? If so, what structural features are relevant for setting policy? A particularly important question is how network structure interacts with other potential sources of contagion. In the run-up to the crisis, leverage levels increased and capital buffers at some banks were extremely thin. Large financial institutions had increased their reliance on short-term Contagion in Financial Networks†