Financial Linkages, Portfolio Choice and Systemic Risk

Financial linkages smooth the shocks faced by individual components of the system, but they also create a wedge between ownership and decision-making. The classical intuition on the role of pooling risk in raising welfare is valid when ownership is evenly dispersed. However, when the ownership of some agents is concentrated in the hands of a few others, greater integration and diversification can lead to excessive risk taking and volatility and result in lower welfare. We also show that individuals undertake too little (too much) risk relative to the first best if the network is homogeneous (heterogeneous), and study optimal networks. ∗Department of Economics, University of Essex, Email: [email protected] †Department of Economics, University of Essex, Email: [email protected] ‡Faculty of Economics and Christ’s College, University of Cambridge. Email: [email protected] We thank Daron Acemoglu, Matt Elliott, Marcel Fafchamps, Stephane Guibaud, Matthew Jackson, Guy Laroque, Francesco Nava, Bruno Strulovici, Jean Tirole, and participants at several seminars for useful comments. Andrea Galeotti acknowledges financial support from the European Research Council (ERC-starting grant 283454). Sanjeev Goyal acknowledges financial support from a Keynes Fellowship and the CambridgeINET Institute.