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Contagious Synchronization and Endogenous Network Formation in Financial Networks

Listed author(s):
  • Christoph Aymanns and Co-Pierre Georg

When banks choose similar investment strategies the financial system becomes vulnerable to common shocks. We model a simple financial system in which banks decide about their investment strategy based on a private belief about the state of the world and a social belief formed from observing the actions of peers. Observing a larger group of peers conveys more information and thus leads to a stronger social belief. Extending the standard model of Bayesian updating in social networks, we show that the probability that banks synchronize their investment strategy on a state non-matching action critically depends on the weighting between private and social belief. This effect is alleviated when banks choose their peers endogenously in a network formation process, internalizing the externalities arising from social learning.

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File URL: http://www.econrsa.org/node/923
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Paper provided by Economic Research Southern Africa in its series Working Papers with number 450.

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Length: 42 pages
Date of creation: 2014
Handle: RePEc:rza:wpaper:450
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