Network Formation and Systemic Risk
38 Pages Posted: 26 Sep 2014
Date Written: August 29, 2014
This paper introduces a model of endogenous network formation and systemic risk. In it, agents form networks that efficiently trade-off the possibility of systemic risk with the benefits of trade. Second, fundamentally ‘safer’ economies generate higher interconnectedness, which in turn leads to higher systemic risk. Third, the structure of the network formed depends on whether the shocks to the system are believed to be correlated or independent of each other. In particular, when shocks are perfectly correlated, the network formed is a complete graph, i.e., a link between every pair of agents. This underlines the importance of specifying the shock structure before investigating a given network because a given network and shock structure could be incompatible.
Keywords: Network Formation, Systemic Risk, Contagion, Rationalizability, Core
JEL Classification: D85, G01
Suggested Citation: Suggested Citation