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The Formation of Financial Networks

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  • Ana Babus

    (Erasmus Universiteit 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. The trade-off between the gains and the risks of being connected shapes banks ’incentives to form links. 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, 2006. "The Formation of Financial Networks," Tinbergen Institute Discussion Papers 06-093/2, Tinbergen Institute.
  • Handle: RePEc:tin:wpaper:20060093
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    More about this item

    Keywords

    financial stability; network formation; contagion risk;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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