Network Formation and Financial Fragility

A tractable model of the formation of financial networks is developed, allowing the use of concepts from portfolio theory. The optimal financial network maximizes a Sharpe ratio defined for financial networks, whereas the equilibrium financial net- work emerges from banks bargaining over future proceeds of co-investment oppor- tunities. Measures of financial fragility, systemic risk and robustness are developed. The equilibrium financial network is shown to be the most connected and with the lowest level of financial fragility, whereas the optimal is the one least connected and with lowest exposure to systemic risk, being also the most robust financial network