Financial fragility and distress propagation in a network of regions

Building on previous works on business fluctuations, we study the propagation of financial distress in a geographical setting. We model a network of regions, each populated by interacting heterogeneous agents, varying the level of interregional connectivity. Given the recent financial turmoils and the growing literature on the diffusion of financial crises, our aim is to identify patterns of failures as firms establish new linkages crossing the borders of their regions. The more they sell goods and obtain credit from abroad, the more the system gets connected, and the financial stability of each actor depends on the financial situation of those located in the neighboring regions. The paper shows that firms can benefit from diversification only at low degree of connectivity. Beyond a certain degree, indeed, an agent may receive the negative shocks hitting agents in other regions and have its financial position affected. As the degree increases further towards a fully connected network, then cascades of failures emerge with consequences on the growth of the whole economy. JEL classification: C63; E32; G01; L14