Network Hazard and Bailouts

Abstract

This paper studies a model of firms with endogenous bilateral exposures and government bailouts. It is shown that the anticipation of bailouts makes firms less concerned with the counterparty choices of their counterparties. This “network hazard” gives rise to large central firms. Bailouts can mitigate contagion but they can not restore output losses. Consequently, idiosyncratic bad shocks to large central firms generate large welfare losses. As such, bailouts create welfare volatility and systemic risk. Surprisingly, moral hazard on risk-return dimension is mitigated by bailouts. Ex-ante regulations can induce discontinuous changes in the network.

Keywords: Contagion, Strategic Network Formation, Strong Stability, Interconnectedness, Core-periphery, Systemic Risk, Volatility, Bailouts, Network Hazard, Moral Hazard, Federal Reserve Act

JEL Classification: D85, G01, H81