Contagious Synchronization and Endogenous Network Formation in Financial Networks

41 Pages Posted: 31 Jul 2014

See all articles by Christoph Aymanns

Christoph Aymanns

London School of Economics & Political Science (LSE) - London School of Economics; University of St. Gallen - School of Finance

Co-Pierre Georg

University of Cape Town; Deutsche Bundesbank

Date Written: July 1, 2014

Abstract

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

Suggested Citation

Aymanns, Christoph and Georg, Co-Pierre, Contagious Synchronization and Endogenous Network Formation in Financial Networks (July 1, 2014). Available at SSRN: https://ssrn.com/abstract=2474293 or http://dx.doi.org/10.2139/ssrn.2474293

Christoph Aymanns

London School of Economics & Political Science (LSE) - London School of Economics ( email )

United Kingdom

University of St. Gallen - School of Finance

Unterer Graben 21
St.Gallen, CH-9000
Switzerland

Co-Pierre Georg (Contact Author)

University of Cape Town ( email )

Private Bag X3
Rondebosch, Western Cape 7701
South Africa

Deutsche Bundesbank ( email )

Wilhelm-Epstein-Str. 14
Frankfurt/Main, 60431
Germany

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