Network Hazard and Bailouts
56 Pages Posted: 12 Sep 2017 Last revised: 14 Oct 2017
Date Written: October 13, 2017
A theory of network formation and contagion is presented and applied to various models of financial and economic contagion. Then the impact of bailouts are studied. Time-consistent bailouts eliminate second-order counterparty risk as a by-product, which is called “network hazard”. Agents become less concerned with the counterparties of their counterparties. Network hazard makes some agents too-big-to-fail and makes the network “more core-periphery.” A larger part of the economy becomes exposed to the core, which increases volatility via the solvency of the core. It is shown that network hazard is a novel force distinct from moral hazard. Results are historically relevant to the establishment of the FED and pyramiding of reserves. The general theory presented shows that strongly stable networks exist and are almost unique in a model of threshold contagion if -an infected node’s payoff does not depend on the number of its infected neighbors and an uninfected node’s payoff decreases in the number of its infected neighbors.
Keywords: Network Formation, Bailouts, Moral Hazard, Systemic Risk, Volatility, Interconnectedness, Core-periphery, Contagion, Rationalizability, Strong stability, Phase transition
JEL Classification: D85, G01, H81
Suggested Citation: Suggested Citation