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Network Formation and Systemic Risk

Author

Listed:
  • Selman Erol

    () (Department of Economics, University of Pennsylvania)

  • Rakesh Vohra

    () (Department of Economics and Department of Electrical & Systems Engineering, University of Pennsylvania)

Abstract

This paper introduces a model of endogenous network formation and systemic risk. In it, agents form networks that efficiently trade-off the possibility of systemic risk with the benefits of trade. Second, fundamentally ‘safer’ economies generate higher interconnectedness, which in turn leads to higher systemic risk. Third, the structure of the network formed depends on whether the shocks to the system are believed to be correlated or independent of each other. In particular, when shocks are perfectly correlated, the network formed is a complete graph, i.e., a link between every pair of agents. This underlines the importance of specifying the shock structure before investigating a given network because a given network and shock structure could be incompatible.

Suggested Citation

  • Selman Erol & Rakesh Vohra, 2014. "Network Formation and Systemic Risk," PIER Working Paper Archive 14-029, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
  • Handle: RePEc:pen:papers:14-029
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    File URL: https://economics.sas.upenn.edu/sites/default/files/filevault/14-029.pdf
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    References listed on IDEAS

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    1. Carlsson, Hans & van Damme, Eric, 1993. "Global Games and Equilibrium Selection," Econometrica, Econometric Society, vol. 61(5), pages 989-1018, September.
    2. Freixas, Xavier & Parigi, Bruno M & Rochet, Jean-Charles, 2000. "Systemic Risk, Interbank Relations, and Liquidity Provision by the Central Bank," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(3), pages 611-638, August.
    3. Ana Babus, 2016. "The formation of financial networks," RAND Journal of Economics, RAND Corporation, vol. 47(2), pages 239-272, May.
    4. Stephen Morris, 2000. "Contagion," Review of Economic Studies, Oxford University Press, vol. 67(1), pages 57-78.
    5. Eboli, Mario, 2013. "A flow network analysis of direct balance-sheet contagion in financial networks," Kiel Working Papers 1862, Kiel Institute for the World Economy (IfW).
    Full references (including those not matched with items on IDEAS)

    Citations

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    Cited by:

    1. Spiros Bougheas, 2017. "Contagion in Stable Networks," CESifo Working Paper Series 6682, CESifo.
    2. Spiros Bougheas, 2017. "Contagion in Stable Networks," Working Papers 2017.50, Fondazione Eni Enrico Mattei.
    3. Zafer Kanık, 2017. "Rescuing the Financial System: Capabilities, Incentives, and Optimal Interbank Networks," Working Papers 17-17, NET Institute.
    4. Barroso, Ricardo Vieira & Lima, Joaquim Ignacio Alves Vasconcellos & Lucchetti, Alexandre Henrique & Cajueiro, Daniel Oliveira, 2016. "Interbank network and regulation policies: an analysis through agent-based simulations with adaptive learning," MPRA Paper 73308, University Library of Munich, Germany.

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    More about this item

    Keywords

    Network Formation; Systemic Risk; Contagion; Rationalizability; Core;
    All these keywords.

    JEL classification:

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

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