The Formation of Financial Networks

Abstract

Modern banking systems are highly interconnected. Despite their various benefits, linkages between banks carry the risk of contagion. In this paper I investigate whether banks can commit ex-ante to mutually insure each other, when there is contagion risk in the financial system. I model banks' decisions to share this risk through bilateral agreements. A financial network that allows losses to be shared among various counterparties arises endogenously. In an equilibrium interbank network the probability of systemic risk, defined as the event that contagion occurs conditional on one bank failing, is at most half. I show that there exists equilibria in which contagion does not occur.

Keywords: financial stability, network formation, contagion risk

JEL Classification: G21, D82