Network Formation and Systemic Risk

55 Pages Posted: 8 Jan 2015 Last revised: 1 Jun 2020

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 5, 2018

Abstract

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

Erol, Selman and Vohra, Rakesh, Network Formation and Systemic Risk (August 5, 2018). Available at SSRN: https://ssrn.com/abstract=2546310 or http://dx.doi.org/10.2139/ssrn.2546310

Selman Erol (Contact Author)

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

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States

Rakesh Vohra

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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