Distress Dispersion and Systemic Risk in Networks∗

I present a model in which heterogeneity in financial distress endogenously generates inefficiencies in network formation, creating excessive systemic risk. Financial firms face costly liquidation and strategically trade assets, thereby forming links. A link with a distressed firm can be socially costly as it increases system-wide liquidation risk. When the cross-sectional dispersion of distress is high, the network composition is distorted in two ways: it features too many links with distressed firms and too few risk-sharing links among non-distressed firms. This inefficiency arises from an externality as bilateral contract terms are not contingent on links faraway in the network. Using insights from the model, I discuss policy implications for financial stability. I also show empirical evidence that the distress dispersion across financial firms provides a novel indicator for systemic risk.