Network Formation and Systemic Risk
55 Pages Posted: 8 Jan 2015 Last revised: 1 Jun 2020
Date Written: August 5, 2018
This paper introduces a simple model of endogenous network formation and systemic risk. In the model, firms form joint ventures called ‘links’ which are subsequently subjected to shocks that are either good or bad. Bad shocks incentivize default. Links yield full benefits only if the counterparty does not subsequently default on the project. Accordingly, defaults triggered by bad shocks render firms insolvent and defaults propagate via links. The model yields three insights. First, stable networks with ex-ante identical agents exhibit a core-periphery structure. Second, an increase in the probability of good shocks increases systemic risk. Third, the network formed critically depends on the correlation between shocks to links. As a consequence, an observer who misconceives the correlation will significantly underestimate the probability of systemwide default.
Keywords: Network Formation, Systemic Risk, Core-periphery, Volatility Paradox, Group Stability.
JEL Classification: D85, G01
Suggested Citation: Suggested Citation