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Network formation and heterogeneous risks

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  • Cabrales, Antonio
  • Gottardi, Piero

Abstract

We study a new model to study the effect of contract externalities that arise through shock transmission. We model a financial network where good firms enjoy direct and indirect benefits from linking with one another. Bad risks benefit from having a connection with a good firm, but they are a cost to both direct and indirect connections. In efficient networks the good risks should form large connected components with very few bad risks attached. The equilibrium networks, on the other hand, have many more bad risks attached, they are core-periphery structures, and components are also smaller than the efficient ones. We also study extensions with heterogenous “bad risks,†with diversity in the costs to good risk firms of linking with bad risks, and with incomplete information.

Suggested Citation

  • Cabrales, Antonio & Gottardi, Piero, 2024. "Network formation and heterogeneous risks," CEPR Discussion Papers 19089, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:19089
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    1. Silva, Thiago Christiano & Guerra, Solange Maria & Tabak, Benjamin Miranda & de Castro Miranda, Rodrigo Cesar, 2016. "Financial networks, bank efficiency and risk-taking," Journal of Financial Stability, Elsevier, vol. 25(C), pages 247-257.
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    3. Alfaro, Laura & Faia, Ester & Lamersdorf, Nora & Saidi, Farzad, 2024. "Altruism, social interactions, and the course of a pandemic," European Economic Review, Elsevier, vol. 161(C).
    4. Ba, Shusong & Li, Lu & Huang, Wenli & Yang, Chen, 2020. "Heterogeneity risks and negative externality," Economic Modelling, Elsevier, vol. 87(C), pages 401-415.
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    More about this item

    Keywords

    Network formation;

    JEL classification:

    • D85 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Network Formation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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