Incentive-Aware Models of Financial Networks

Abstract

A financial network is a web of contracts between firms. Each firm wants the best possible contracts. However, a contract between two firms requires the cooperation of both firms. This contest between cooperation and competition is studied in “Incentive-Aware Models of Financial Networks” by Akhil Jalan, Deepayan Chakrabarti, and Purnamrita Sarkar. They show how contract negotiations lead to a stable network where no firm wants to change contract sizes. In this network, the size of any contract depends on the beliefs of all firms, not just the contract’s two parties. Minor news about one firm can affect these beliefs, causing drastic changes in the network. Moreover, under realistic settings, a regulator cannot trace the source of such changes. This research illustrates the importance of firms’ beliefs and their implications for network stability. The insights could inform regulatory strategies and financial risk management.