Network formation and its impact on systemic risk

In the aftermath of the financial crisis of 2008, many policy makers and researchers pointed to the interconnectedness of the financial system as one of the fundamental contributors to systemic risk. The argument is that the linkages between financial institutions served as an amplification mechanism: shocks to smaller parts of the system propagate through the system and result in broad damage to the financial system. In my dissertation, I explore the formation of networks when agents take into account systemic risk. The dissertation consists of three complementary papers on this topic. The first paper titled “Network Formation and Systemic Risk\u27\u27, joint with Professor Rakesh Vohra. We set out the framework and construct a model of endogenous network formation and systemic risk. We find that fundamentally \u27safer\u27 economies with higher probability of getting good shocks generate higher interconnectedness, which leads to higher systemic risk. This provides network foundations for “the volatility paradox\u27\u27 arguing that better fundamentals lead to worse outcomes due to excessive risk taking. Second, the network formed crucially depends on the correlation of shocks to the system. The third result is that the networks formed in the model are utilitarian efficient because the risk of contagion is high. This causes firms to minimize contagion by forming dense but isolated clusters that serve as firebreaks. This finding is suggestive that, the worse the contagion, the more the market takes care of it. In the second paper, titled “Network Hazard and Bailouts\u27\u27, I ask how the anticipation of ex-post government bailouts affects network formation. I deploy a significant generalization of the model in the first paper and allow for time-consistent government transfers. I find that the presence of government bailouts introduces a novel channel for moral hazard via its effect on network architecture, which I call “network hazard\u27\u27. In the final paper, titled “Network Reactions to Banking Regulations”, joint with Professor Guilermo Ordonez, we consider the role of liquidity and capital requirements to alleviate network hazard and systemic risk. In the model, financial firms set up credit lines with each other in order to meet their funding needs on demand. Accordingly, higher liquidity requirements induce firms to form higher interconnectedness in order to be able to find deposits as needed. At a tipping point of liquidity requirements, the network discontinuously jumps in its interconnectedness, which contributes discontinuously to systemic risk. On the other hand, the reaction to capital requirements is smooth. Capital requirements indirectly work as an upper bound in the interconnectedness firms would form. This way, interconnectedness can be effectively reduced to a desired level via capital requirements. Yet capital requirements cannot be used to induce higher interconnectedness. Thusly, in times of credit freeze, capital requirements may not help promote circulation of credit. A conjunction of both liquidity and capital requirements is more effective in promoting desired circulation while reducing systemic risk. (Abstract shortened by ProQuest.