Distorted Investment Incentives, Regulation, and Equilibrium Multiplicity in a Model of Financial Networks

In a model of financial networks that admits both debt and equity interdependencies, we show that financial organizations have incentives to choose excessively risky portfolios, and overly correlate their portfolios with those of their counterparties. We show how optimal regulation depends on specific measures of financial centrality that capture how a given organization's portfolio affects the values and defaults of other organizations. Additionally, we provide a comprehensive analysis of the multiplicity of equilibrium values for banks, which increases the fragility of the financial network. Multiplicity arises if and only if there exists a certain type of dependency cycle in the network and that those cycles admit self-fulfilling default cascades. We fully characterize the minimum bailouts needed to ensure systemic solvency. We show that the bailouts needed to eliminate self-fulfilling cycles of defaults are fully recoverable, while those needed to prevent cascading defaults in the best equilibrium are not