Contagious Synchronization and Endogenous Network Formation in Financial Networks

TL;DR

This paper models how banks' investment strategies become synchronized through social learning and endogenous network formation, highlighting the impact of private versus social beliefs on systemic risk.

Contribution

It extends Bayesian social learning models by incorporating endogenous network formation, showing how banks internalize externalities in their peer selection process.

Findings

Synchronization probability depends on private and social belief weighting

Endogenous network formation reduces synchronization risk

Banks internalize externalities in peer selection

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.