Network formation and systemic risk

This paper introduces a model of endogenous network formation and systemic risk. In it, firms form joint ventures called ‘links’ which are subsequently subjected to either good or bad shocks. Bad shocks incentivize default. Links yield full benefits only if the counter-party does not default on project. Accordingly, defaults triggered by render insolvent propagate via links. The yields three insights. First, stable networks with ex-ante identical agents exhibit core–periphery structure. Second, an increase in probability increases Third, because formed depends correlation between links, observer who misconceives will underestimate system-wide factor half.