Limit Theorems for Default Contagion and Systemic Risk

Abstract

We consider a general tractable model for default contagion and systemic risk in a heterogeneous financial network subjected to an exogenous macroeconomic shock. We show that under certain regularity assumptions, the default cascade model can be transformed into a death process problem represented by a balls-and-bins model. We state various limit theorems regarding the final size of default cascades. Under appropriate assumptions on the degree and threshold distributions, we prove that the final sizes of default cascades have asymptotically Gaussian fluctuations. We next state limit theorems for different system-wide wealth aggregation functions, which enable us to provide systemic risk measures in relation to the structure and heterogeneity of the financial network. Lastly, we demonstrate how these results can be utilized by a social planner to optimally target interventions during a financial crisis given a budget constraint and under partial information of the financial network.