To read this content please select one of the options below:

Efficiency, stability, and government regulation of risk-sharing financial networks

Porchiung Ben Chou (Martin Tuchman School of Management, New Jersey Institute of Technology, Newark, New Jersey, USA)
Michael A. Ehrlich (Martin Tuchman School of Management, New Jersey Institute of Technology, Newark, New Jersey, USA)
Ronald Sverdlove (Sy Syms School of Business, Yeshiva University, New York, New York, USA)

Managerial Finance

ISSN: 0307-4358

Article publication date: 23 May 2019

Issue publication date: 23 May 2019

224

Abstract

Purpose

By applying models of social and economic networks to financial institutions, the purpose of this paper is to address the issues of how policy makers can promote financial network stability and social efficiency.

Design/methodology/approach

The authors characterize the decentralized network formation of financial institutions in three stages through which institutions choose to become member banks connected to a central bank, bank-holding company subsidiaries or non-banks. Financial institutions choose one of the three roles in an endogenous process by considering the effects of sharing shocks among the members of the network. In the model, there is a social-welfare-maximizing government regulator at the center of the network.

Findings

The authors show that the stable equilibrium network is not always the efficient network, so the central authority must use policy instruments to ensure that the stable equilibrium network is as close as possible to the efficient network.

Research limitations/implications

To obtain the theoretical results, the authors make assumptions about the utility function and risk aversion of a financial institution, as well as about the costs of network formation. These assumptions might need to be relaxed to bring the model closer to real-world institutions.

Practical implications

The results suggest that regulators must try to set their policy variables to make the efficient network as close as possible to the stable network.

Originality/value

The contribution is to incorporate concepts from social network theory into the modeling of financial networks. The results may be of use to regulators in maintaining the stability of the financial system.

Keywords

Acknowledgements

The authors would like to thank Dr William V. Rapp and the Leir Foundation for financial support for an early version of this paper.

Citation

Chou, P.B., Ehrlich, M.A. and Sverdlove, R. (2019), "Efficiency, stability, and government regulation of risk-sharing financial networks", Managerial Finance, Vol. 45 No. 6, pp. 760-780. https://doi.org/10.1108/MF-06-2018-0287

Publisher

:

Emerald Publishing Limited

Copyright © 2019, Emerald Publishing Limited

Related articles