Network Formation and Systemic Risk

October 06, 2017, Webb 1100

Rakesh Vohra

University of Pennsylvania, Economics


This paper introduces a model of endogenous network formation and systemic risk. In the model a link represents a trading opportunity that yields benefits only if the counterparty does not subsequently default. After links are formed, they are subjected to exogenous shocks that are either good or bad. Bad shocks reduce returns from links and incentivize default. Good shocks, the reverse. Defaults triggered by bad shocks might propagate via links. The model yields three insights. The first concerns the volatility paradox. A higher probability of good shocks generates a higher systemic risk because increased interconnectedness in the network offsets the effect of better fundamentals. Second, the networks formed in the model are utilitarian efficient. The former is a consequence of contagion being triggered too often, whereas the latter is a consequence of contagion spreading easily. Third, the network formed critically depends on the correlation between shocks to the links. As a consequence, an outside observer who misconceives the correlation structure of shocks, upon observing a highly interconnected network, will significantly underestimate the probability of system wide default. This is based on joint work with Selman Erol.

Speaker's Bio

Professor Vohra is a leading global expert in mechanism design, an innovative area of game theory that brings together economics, engineering and computer science. His economics research in mechanism design focuses on the best ways to allocate scarce resources when the information required to make the allocation is dispersed and privately held, an increasingly common condition in present-day environments. His work has been critical to the development of game, auction and pricing theory — for example, the keyword auctions central to online search engines — and spans such areas as operations research, market systems and optimal pricing mechanisms.
He formerly taught at Northwestern University, where he was the John L. and Helen Kellogg Professor of Managerial Economics and Decision Sciences in the Kellogg School of Management, with additional appointments in the Department of Economics and the Department of Electrical Engineering and Computer Science. He taught from 1985 to 1998 in the Fisher College of Business at Ohio State University. He earned a Ph.D. in mathematics in 1985 from the University of Maryland, an M.Sc. in operational research in 1981 from the London School of Economics and a B.Sc. (Hon.) in mathematics in 1980 from University College London.
He came to Penn as part as of the Penn Integrates Knowledge program that President Amy Guttmann established in 2005 as a University-wide initiative to recruit exceptional faculty members whose research and teaching exemplify the integration of knowledge across disciplines. His appointment is shared with the Department of Electrical and Systems Engineering in the School of Engineering and Applied Science.