Journal of Banking & Finance Vol. 50 2015
Contagious synchronization and endogenous network formation in financial networks
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.
- DOI
- 10.1016/j.jbankfin.2014.06.030
- Volume
- 50
- Pages
- 273-285
- Language
- en
- Sources
- bibtex:phds-export.bib openalex crossref