Risk-sharing and contagion network

Abstract

We investigate the properties of financial networks that allow to optimally solve the trade-off between higher risk-sharing and contagion. With continuous shock distributions, the optimum features the segmentation of the system of firms into disjoint components, with uniform exposure within them. With positive mass on some large shocks, it is instead optimal to modulate the exposure level to different firms. When firms are heterogeneous in the risk characteristics of their shocks, optimality requires homogeneous components, while with heterogeneity in size, an irrelevance result holds. Also, the incentives of firms to establish linkages may not be aligned with social optimality.