Systemic Risk in Endogenous Financial Networks∗

We provide a framework to study the formation of financial networks and investigate the interplay between the banks’ lending incentives and the emergence of systemic risk. We show that under natural contracting assumptions, banks fail to internalize the implications of their lending decisions for the banks with whom they are not directly contracting, thus establishing the presence of a financial network externality in the process of network formation. We then illustrate how the presence of this externality can function as a channel for the emergence of systemic risk. In particular, we show that (i) banks may “overlend” in equilibrium, creating channels over which idiosyncratic shocks can translate into systemic crises via financial contagion; and (ii) they may not spread their lending sufficiently among the set of potential borrowers, creating insufficiently connected financial networks that are excessively prone to contagious defaults. Finally, we show that banks’ private incentives may lead to the formation of financial networks that are overly susceptible to systemic meltdowns with some small probability.