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The Formation of Financial Networks

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  • Ana Babus

    (Erasmus University Rotterdam)

Abstract

Modern 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.

Suggested Citation

  • Ana Babus, 2007. "The Formation of Financial Networks," Working Papers 2007.69, Fondazione Eni Enrico Mattei.
  • Handle: RePEc:fem:femwpa:2007.69
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Financial Stability; Network Formation; Contagion Risk;

    JEL classification:

    • 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

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