Contagious Synchronization and Endogenous Network Formation in Financial Networks
arXiv:1408.0440 · doi:10.1016/j.jbankfin.2014.06.030
Abstract
When banks choose similar investment strategies the financial system becomes vulnerable to common shocks. We model a simple financial system in which banks decide about their investment strategy based on a private belief about the state of the world and a social belief formed from observing the actions of peers. Observing a larger group of peers conveys more information and thus leads to a stronger social belief. Extending the standard model of Bayesian updating in social networks, we show that the probability that banks synchronize their investment strategy on a state non-matching action critically depends on the weighting between private and social belief. This effect is alleviated when banks choose their peers endogenously in a network formation process, internalizing the externalities arising from social learning.
41 pages, 10 figures, Journal of Banking & Finance 2014