Distress Dispersion and Systemic Risk in Networks∗

I develop a model in which heterogeneity in financial distress endogenously generates in-efficiencies in network formation, creating excessive systemic risk. Financial firms face costly liquidation and strategically trade assets, thereby forming links. A link with a distressed firm can be socially costly as it raises system-wide liquidation risk. When firms are highly dispersed in financial distress, the network composition is distorted in two ways: it features too many links with distressed firms and too few risk-sharing links among non-distressed firms. This inefficiency arises from an externality when bilateral trading terms are not con-tingent on links faraway in the network. Using insights from the model, I discuss policy implications for financial stability. I also show empirical evidence that the distress disper-sion across financial firms provides a novel indicator for systemic risk