The Formation of Financial Networks

Ana Babus
2007 Social Science Research Network  
Modern banking systems are highly interconnected. Despite various bene...ts, 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 ...nancial system. I model banks'decisions to share this risk through bilateral agreements. A ...nancial network that allows losses to be shared among various counterparties arises endogenously. I characterize the probability of systemic
more » ... de...ned as the event that contagion occurs conditional on one bank failing, in equilibrium interbank networks. I show that there exist equilibria in which contagion does not occur.
doi:10.2139/ssrn.939754 fatcat:falctfpyhbflxi3uv4ne7h6kwi