Financial networks Analysis and Policy Implications

The student will contribute to building a prototype of a financial network model which integrates the two most prominent approaches of financial contagion: (i) counterparty risk contagion, and (ii) contagion from portfolio overlaps. The student will build on the work done by the former REU, who worked under the PI's supervision last year. She built a stylized strategic network model, in which financial agents react to price shocks and adjust their leverage to meet prescribed requirements. She has shown that the Nash equilibrium of the resulting game can be recovered as the equilibrium of a potential game. This year's student will build upon the former REU's work, and construct simple models for strategically deciding how banks enter into bilateral contractual relationships with other banks in the network. The PI's expectation is that, by the end of the summer, the student will construct a numerical tool for approximating the network equilibrium, and that the tool is flexible enough to incorporate policy constraints. The PI plans to use this tool to analyze how the private network equilibrium of banks in the network adapts to policies, and how close it is to the social optimum. The ultimate objective is to design the policies that better align private banks' incentives with the social optimum.