This paper introduces a model of endogenous network formation and systemic risk. In it, strategic agents form networks that efficiently trade-off the possibility of systemic risk with the benefits of trade. Efficiency is a consequence of the high risk of contagion which forces agents to endogenize their externalities. Second, fundamentally 'safer' economies generate much higher interconnectedness, which in turn leads to higher systemic risk. Third, the structure of the network formed depends

more »

... cially on whether the shocks to the system are believed to be correlated or independent of each other. This underlines the importance of specifying the shock structure before investigating a given network as a particular network and shock structure could be incompatible. JEL classification: D85, G01. ). Our model suggests that underlying structural weaknesses (as modeled by strong correlations between shocks) and greater interconnectedness can coexist. Therefore, it would be incorrect to highlight the interconnectedness of the system and suggest it alone as the cause of instability. Our model differs from the prior literature in three important ways. 1. The networks we study are formed endogenously. Babus (2013) also has a model of network formation, but one in which agents share the goal of minimizing the probability of system wide default. In our model agents are concerned with their own expected payoffs and only indirectly with the possibility of system wide failure. Acemoglu et al. (2013) also discusses network formation, but the links permitted to form are constrained by an exogenously given 'opportunity' network is exogenously given. If the opportunity network is complete then all links are permitted. However, the networks that are compared in their paper arise from different opportunity networks; one complete and the other a ring. When the opportunity network is complete, agents form a complete network. When the opportunity network is a ring, agents form a ring. In our model, agents are free to partner with anyone and we compare networks that arise within the same world of possibilities. In this sense our network formation is genuinely endogenous. Zawadowski (2013) models the decision of agents to purchase default insurance on their counter-parties. This can be interpreted as a model of network formation, but it is not a model of an agent choosing a particular counter-party. Rather, the counter-parties are fixed, and default insurance serves to change the terms of trade with an existing counter-party. The model in Farboodi (2014) includes network formation with the same solution concept we employ. However, the models are different. In particular, default in her model is not strategic. Blume et al. (2013) has networks that form endogenously. However, the risk of a node defaulting is non-strategic and independent of the network formed. In our model, the likelihood of a node defaulting depends on the structure of the network formed. 2. We examine the effects of a distribution that generates the shocks rather than the effects of fixed shocks applied to particular nodes. Glasserman and Young (2014) is the only exception we are aware of, but the networks they consider are exogenously given. 3. The decision to default in our model is strategic. We are unaware of prior work that incorporates this.