I prove that strongly stable networks exist and are almost unique in a model of threshold contagion if -an infected node’s payoff does not depend on the number of its infected neighbors- and -an uninfected node’s payoff decreases in the number of its infected neighbors-. Then I apply this theory to various models of financial and economic contagion with endogenous network formation in which a government intervenes to stop contagion. In the absence of bailouts, the network formed consists of small clusters that are sparsely connected. Time-consistent bailouts eliminate second-order counterparty risk as a by-product, introducing a novel form of hazard via their effect on network architecture, dubbed network hazard. As a result, the network becomes interconnected and exhibits a core-periphery structure wherein many agents (periphery) are connected to a smaller number of central agents (core). Interconnectedness within the periphery increases spillovers. Core serves as a buffer when solvent and an amplifier when insolvent. Therefore, ex-post time-consistent intervention increases systemic risk and volatility through its effect on network formation. However, ex-ante welfare is improved because first-order counterparty risk remains unchanged by bailouts.
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. First, a higher probability of good shocks generates a higher probability of system wide default because increased interconnectedness in the network offsets the effect of better fundamentals. Second, 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 underestimate the probability of system wide default. Third, when the risk of contagion is high, the networks formed in the model are utilitarian efficient.