The Formation of Financial Networks
AbstractModern banking systems are highly interconnected. Despite their various benefits, the linkages that exist between banks carry the risk of contagion. In this paper we investigate how banks decide on direct balance sheet linkages and the implications for contagion risk. In particular, we model a network formation process in the banking system. Banks form links order to reduce the risk of contagion. The network is formed endogenously and serves as an insurance mechanism. We show that banks manage to form networks that are resilient to contagion. Thus, in an equilibrium network, the probability of contagion is virtually 0.
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Bibliographic InfoPaper provided by Fondazione Eni Enrico Mattei in its series Working Papers with number 2007.69.
Date of creation: Jun 2007
Date of revision:
Financial Stability; Network Formation; Contagion Risk;
Other versions of this item:
- C70 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - General
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
This paper has been announced in the following NEP Reports:
- NEP-ALL-2007-07-07 (All new papers)
- NEP-BAN-2007-07-07 (Banking)
- NEP-FMK-2007-07-07 (Financial Markets)
- NEP-GTH-2007-07-07 (Game Theory)
- NEP-NET-2007-07-07 (Network Economics)
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