Endogenous Financial Networks: Efficient Modularity and Why Shareholders Prevent it

We model the implications for systemic risk in financial networks of the classic conflict of interest between debt-holders and equity-holders (Merton, 1974). Financial connections help diversify banks' idiosyncratic risk and avoid failures following small shocks, but increase the risk of contagion following large shocks. A social planner resolves this trade-off by creating a modular network structure with fire breaks, thereby diversifying away banks' exposures to small shocks while containing contagion. These socially efficient networks suit debt-holders' interests, but run counter to equity-holders' interests. They transfer surplus value from the equity-holders of healthy banks to the debt-holders of distressed banks. Equity-holders can profitably trade away from these networks, and so socially optimal networks are unstable. Moreover, trades are profitable for equity holders when they align counter-parties' failures with their own, creating systemic risk.