Systemic Risk in Endogenous Financial Networks

29 Pages Posted: 23 Jan 2015

See all articles by Daron Acemoglu

Daron Acemoglu

Massachusetts Institute of Technology (MIT) - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Asuman E. Ozdaglar

Massachusetts Institute of Technology (MIT) - Department of Electrical Engineering and Computer Science

Alireza Tahbaz-Salehi

Northwestern University - Kellogg School of Management; Centre for Economic Policy Research (CEPR)

Date Written: January 22, 2015

Abstract

We provide a framework to study the formation of financial networks and investigate the interplay between banks' lending incentives and the emergence of systemic risk. We show that under natural contracting assumptions, banks fail to internalize the implications of their lending decisions for the banks with whom they are not directly contracting, thus establishing the presence of a financial network externality in the process of network formation. We then illustrate how the presence of this externality can function as a channel for the emergence of systemic risk. In particular, we show that (i) banks may "overlend" in equilibrium, creating channels over which idiosyncratic shocks can translate into systemic crises via financial contagion; and (ii) they may not spread their lending sufficiently among the set of potential borrowers, creating insufficiently connected financial networks that are excessively prone to contagious defaults. Finally, we show that banks' private incentives may lead to the formation of financial networks that are overly susceptible to systemic meltdowns with some small probability.

Keywords: systemic Risk, financial network, network formation, contagion

JEL Classification: G01, D85

Suggested Citation

Acemoglu, Daron and Ozdaglar, Asuman E. and Tahbaz-Salehi, Alireza, Systemic Risk in Endogenous Financial Networks (January 22, 2015). Columbia Business School Research Paper No. 15-17, Available at SSRN: https://ssrn.com/abstract=2553900 or http://dx.doi.org/10.2139/ssrn.2553900

Daron Acemoglu

Massachusetts Institute of Technology (MIT) - Department of Economics ( email )

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Centre for Economic Policy Research (CEPR)

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National Bureau of Economic Research (NBER)

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Asuman E. Ozdaglar

Massachusetts Institute of Technology (MIT) - Department of Electrical Engineering and Computer Science ( email )

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Alireza Tahbaz-Salehi (Contact Author)

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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