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Network formation and systemic risk

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  • Erol, Selman
  • Vohra, Rakesh

Abstract

This paper introduces a model of endogenous network formation and systemic risk. In it, firms form joint ventures called ‘links’ which are subsequently subjected to either good or bad shocks. Bad shocks incentivize default. Links yield full benefits only if the counter-party 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, because the network formed depends on the correlation between shocks to links, an observer who misconceives the correlation will underestimate the probability of system-wide default by a factor of a half.

Suggested Citation

  • Erol, Selman & Vohra, Rakesh, 2022. "Network formation and systemic risk," European Economic Review, Elsevier, vol. 148(C).
    • Handle: RePEc:eee:eecrev:v:148:y:2022:i:c:s0014292122001222
    DOI: 10.1016/j.euroecorev.2022.104213
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    References listed on IDEAS

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    Cited by:

    1. Elliott, M. & Golub, B. & Leduc, M. V., 2023. "Corporate Culture and Organizational Fragility," Cambridge Working Papers in Economics 2314, Faculty of Economics, University of Cambridge.
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    4. Ling, Aifan & Li, Jinlong & Zhang, Yugui, 2023. "Can firms with higher ESG ratings bear higher bank systemic tail risk spillover?—Evidence from Chinese A-share market," Pacific-Basin Finance Journal, Elsevier, vol. 80(C).

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    More about this item

    Keywords

    Network formation; Systemic risk; Core–periphery; Volatility paradox; Group stability;
    All these keywords.

    JEL classification:

    • D85 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Network Formation
    • G01 - Financial Economics - - General - - - Financial Crises

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