Heterogeneity and Stability: Bolster the Strong, Not the Weak

Abstract

We first study a stylized model of self-fulfilling panic among agents with differing fragilities to strategic risk and show that depending on the severity of coordination problems, the panic trigger threshold can depend only on one type's fragility. We then present a model of systemic panic among financial institutions with heterogeneous fragilities to financial spillovers. Concerns about potential spillovers generate strategic interaction, triggering a pre-emption game in which one tries to exit the market before others to avoid spillovers. Although financial contagion originates in weaker institutions, systemic risk can critically depend on financial health of stronger in the contagion chain. In this case, bolstering the strong, rather than the weak, more effectively enhances systemic stability.

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