Network formation and systemic risk

Selman Erol and Rakesh Vohra

European Economic Review, 2022, vol. 148, issue C

Abstract: This paper introduces a model of endogenous network formation and systemic risk. In it, firms form joint ventures called ‘links’ which are subsequently subjected to either good or bad shocks. Bad shocks incentivize default. Links yield full benefits only if the counter-party does not subsequently default on the project. Accordingly, defaults triggered by bad shocks render firms insolvent and defaults propagate via links. The model yields three insights. First, stable networks with ex-ante identical agents exhibit a core–periphery structure. Second, an increase in the probability of good shocks increases systemic risk. Third, because the network formed depends on the correlation between shocks to links, an observer who misconceives the correlation will underestimate the probability of system-wide default by a factor of a half.

Keywords: Network formation; Systemic risk; Core–periphery; Volatility paradox; Group stability (search for similar items in EconPapers)
JEL-codes: D85 G01 (search for similar items in EconPapers)
Date: 2022
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:eecrev:v:148:y:2022:i:c:s0014292122001222

DOI: 10.1016/j.euroecorev.2022.104213

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