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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

    as
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    2. Matthew Elliott & Benjamin Golub & Matthew O. Jackson, 2014. "Financial Networks and Contagion," American Economic Review, American Economic Association, vol. 104(10), pages 3115-3153, October.
    3. Daron Acemoglu & Asuman Ozdaglar & Alireza Tahbaz-Salehi, 2015. "Systemic Risk and Stability in Financial Networks," American Economic Review, American Economic Association, vol. 105(2), pages 564-608, February.
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    5. Ana Babus, 2016. "The formation of financial networks," RAND Journal of Economics, RAND Corporation, vol. 47(2), pages 239-272, May.
    6. 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.
    7. Larry Eisenberg & Thomas H. Noe, 2001. "Systemic Risk in Financial Systems," Management Science, INFORMS, vol. 47(2), pages 236-249, February.
    8. Gai, Prasanna & Haldane, Andrew & Kapadia, Sujit, 2011. "Complexity, concentration and contagion," Journal of Monetary Economics, Elsevier, vol. 58(5), pages 453-470.
    9. Adam Zawadowski, 2013. "Entangled Financial Systems," The Review of Financial Studies, Society for Financial Studies, vol. 26(5), pages 1291-1323.
    10. 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 Kiel).
    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," Working Papers 2017.50, Fondazione Eni Enrico Mattei.
    2. Elliott, Matthew & Georg, Co-Pierre & Hazell, Jonathon, 2021. "Systemic risk shifting in financial networks," Journal of Economic Theory, Elsevier, vol. 191(C).
    3. Bougheas, Spiros, 2022. "Contagion in networks: Stability and efficiency," Mathematical Social Sciences, Elsevier, vol. 115(C), pages 64-77.
    4. Elliott, Matthew & Georg, Co-Pierre & Hazell, Jonathon, 2021. "Systemic risk shifting in financial networks," LSE Research Online Documents on Economics 123924, London School of Economics and Political Science, LSE Library.
    5. Zafer Kanık, 2017. "Rescuing the Financial System: Capabilities, Incentives, and Optimal Interbank Networks," Working Papers 17-17, NET Institute.
    6. Elliott, M. & Georg, C-P. & Hazell, J., 2020. "Systemic Risk-Shifting in Financial Networks," Cambridge Working Papers in Economics 2068, Faculty of Economics, University of Cambridge.
    7. Paul Glasserman & Peyton Young, 2015. "Contagion in Financial Networks," Economics Series Working Papers 764, University of Oxford, Department of Economics.
    8. Paul Glasserman & H. Peyton Young, 2015. "Contagion in Financial Networks," Working Papers 15-21, Office of Financial Research, US Department of the Treasury.
    9. 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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