Network Formation and Systemic Risk

38 Pages Posted: 26 Sep 2014

See all articles by Selman Erol

Selman Erol

Carnegie Mellon University - David A. Tepper School of Business

Rakesh Vohra

University of Pennsylvania - Department of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: August 29, 2014

Abstract

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

Erol, Selman and Vohra, Rakesh, Network Formation and Systemic Risk (August 29, 2014). PIER Working Paper No. 14-029. Available at SSRN: https://ssrn.com/abstract=2500846 or http://dx.doi.org/10.2139/ssrn.2500846

Selman Erol

Carnegie Mellon University - David A. Tepper School of Business ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States

Rakesh Vohra (Contact Author)

University of Pennsylvania - Department of Economics ( email )

Ronald O. Perelman Center for Political Science
133 South 36th Street
Philadelphia, PA 19104-6297
United States

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