Interconnectedness among firms can accelerate the propagation of financial stress, with the speed of transmission varying according to the strength of interactions between them. Recent empirical evidence suggests that since the 1980s, the economy has been teetering on the brink of a tipping point, creating conditions that make the contagion of distress more probable and exerting a significant impact on risk premia.

Research from Bocconi University explores the impact of such propagation of distress shocks through networks on things such as prices and risk premia.

The researchers classified firms within a network based on their level of vulnerability to financial distress and their systemic impact on other firms. Surprisingly, the research has revealed two distinct equilibria within the network:

• In a subcritical equilibrium, where inter-firm interaction is weak, a financial shock affecting a single firm or a small group of firms will not spread throughout the network. This is due to the limited interconnectedness of firms in the network, which acts as a safeguard against the propagation of distress.
• In contrast, a supercritical equilibrium emerges above a critical level of interaction, known as the tipping point, where distress shocks become contagious, resulting in a cascade of financial distress throughout the network. In these cases, even small shocks can cause systemic crises, triggering domino effects.

One important distinction between subcritical and supercritical equilibria is the way in which investors price in the effects of cascades. In a subcritical equilibrium, investors can easily diversify their portfolios to mitigate the effects of firm-specific shocks.

However, in a supercritical equilibrium, seemingly isolated shocks can develop into cascades that have long-lasting systemic effects, making diversification difficult. Consequently, investors demand a premium to compensate for the risk of exposure to financial distress outbreaks in the network.

Systemic risk

Empirical evidence upholds the theoretical analysis, confirming that an additional systemic risk premium component – not present in traditional models – justifies various intriguing stylized facts. The model predicts the perplexing “deep value” effect, wherein the disparity in valuation between “value” stocks (characterized by high dividend-to-price ratios) and “growth” stocks (characterized by low dividend-to-price ratios) widens, thereby signaling a trading opportunity of “buy the deep.”

Furthermore, the analysis reveals that the interconnectedness and network properties fluctuate with time. Specifically, a structural break in the long-term expected level of distress was identified in 1984, marking a transition to a supercritical equilibrium state after a significant alteration in US bankruptcy law. Subsequent to this transition, the data suggests that the economy hovers marginally above the tipping point in a supercritical equilibrium.