Contagious Synchronization and Endogenous Network Formation in Financial Networks
41 Pages Posted: 31 Jul 2014
Date Written: July 1, 2014
When banks choose similar investment strategies the financial system becomes vulnerable to common shocks. We model a simple financial system in which banks decide about their investment strategy based on a private belief about the state of the world and a social belief formed from observing the actions of peers. Observing a larger group of peers conveys more information and thus leads to a stronger social belief. Extending the standard model of Bayesian updating in social networks, we show that the probability that banks synchronize their investment strategy on a state non-matching action critically depends on the weighting between private and social belief. This effect is alleviated when banks choose their peers endogenously in a network formation process, internalizing the externalities arising from social learning.
Keywords: social learning, endogenous financial networks, multi-agent simulations, systemic risk
JEL Classification: G21, C73, D53, D85
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