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Staff Reports

Heterogeneity and Stability: Bolster the Strong, Not the Weak

September 2013 Number 637

JEL classification: G00, G01

Author: Dong Beom Choi

This paper provides a model of systemic panic among financial institutions with heterogeneous fragilities. Concerns about potential spillovers from each other generate strategic interaction among institutions, triggering a preemption game in which one tries to exit the market before the others to avoid spillovers. Although financial contagion originates in weaker institutions, systemic risk depends critically on the financial health of stronger institutions in the contagion chain. This analysis suggests that when concerns about spillovers prevail, then
1) increasing heterogeneity of institutions promotes systemic stability and
2) bolstering the strong institutions in the contagion chain, rather than the weak, more effectively enhances systemic stability.

Available only in PDF pdf

53 pages / 749 kb

For a published version of this report, see Dong Beom Choi, "Heterogeneity and Stability: Bolster the Strong, Not the Weak,"
Review of Financial Studies 27, no. 6 (May 2014): 1830-67.

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