Contagion of Financial Crises un- der Local and Global Networks

As the world economy becomes increasingly global, will the financial sector become more stable or fragile? In this paper we study how the pattern of relations linking financial institutions - the network - affects the diffusion of a financial crisis. We analyze two such networks with a computational model: the local network, in which each bank is allowed to interact only with the most immediate neighbors, and the global network, in which each bank is allowed to interact with banks located anywhere in the system.We find that the network matters both for the amount of illiquidity in the system and for the spread of bankruptcy. When interactions are local, bankruptcy spreads slower but illiquidity hits harder. When interactions are global, bankruptcy spreads faster, but illiquidity presents fewer problems. We conclude that a global system, in which financial institutions are not restricted to interact only with close neighbors, is more efficient in collecting and allocating funds, but is more vulnerable to contagion of bankruptcy crises.