Endogenous Risk Exposure and Systemic Instability II: Banks Take More Risk in the Least Equilibrium of a Complete Network than of a Ring NetworkResearch Paper
Motivation
Banks lend to one another, and the shape of the resulting network decides how a loss at one bank reaches the others. A long line of work, starting with Allen and Gale (2000) and continued by Acemoglu, Ozdaglar and Tahbaz-Salehi (2015), compares the ring network, where each bank is owed money by one neighbour, with the complete network, where every bank holds an equal share of every other bank's debt. That literature studies contagion after shocks hit and finds that the complete network spreads losses thinly and can absorb small shocks better.
Shu's paper (Management Science, doi:10.1287/mnsc.2022.01519) asks the ex-ante question: when banks choose how much risk to take, knowing the network they sit in, which network makes them take more? A successful bank subsidizes its failed counterparties through the clearing of interbank debt, and anticipating that subsidy pushes it toward riskier projects. Proposition 4 of the paper says that this effect is stronger in the complete network. This mission formalizes that proposition and the computation behind it.
Setting
There are banks. In a regular network with share matrix , bank owes bank the face value , every bank has total interbank liability , and every bank also owes a senior deposit . The two networks of Definition 3 are
Each bank chooses a project in a common interval . The project pays with probability and otherwise, independently across banks. Assumption 1 requires , decreasing, and concave. The standing assumption says a successful bank never defaults.
After the state is realized, interbank payments clear. A payment equilibrium is a vector with
where if bank succeeds and if it fails. Bank 's profit is . A risk-taking equilibrium is a profile in which each maximizes bank 's expected profit given . Equilibria need not be unique, and the paper selects the least one.
The key quantity is the network risk-taking distortion
which is bank 's expected net interbank payment to the other banks when its own project succeeds. In a regular network, expected profit equals , so acts like extra debt that the bank repays only when it succeeds. Superscripts and mark the complete and ring networks.
Formalization targets
Goal: Proposition 4
With the least equilibrium of the complete network and the least equilibrium of the ring,
Milestones
- Clearing in the complete network (IA p. 15): a failed bank pays , where is the number of successful banks.
- (I.13): with the common success probability of the other banks and ,
- (I.14): in the ring, a failed bank pays , where counts the consecutive failed banks upstream of , starting with itself.
- (I.15): the conditional distribution, given failures, of what a successful bank receives in the ring.
- Closed form of (IA p. 16, also p. 14).
- Lemma I.A (ii): . Part (i), the classical hockey-stick identity, is already published and proved on the platform and is included by reference.
- Lemma I.B: whenever .
- when all other banks choose the same project.
Significance
The result. Proposition 4 reverses the conventional reading of the complete network as the safer structure. The co-insurance that makes it resilient after a shock is the same cross-subsidy that weakens incentives before the shock. Two networks with the same face-value liabilities therefore induce different equilibrium risk-taking. Liabilities alone are not a sufficient statistic for risk incentives, and the network topology matters in its own right. The same comparison is the template for the paper's later results on the number of banks and on central clearing.
Formalizing it. The proposition is proved in the paper, not open, and none of it is machine-checked yet. A formal proof must establish the two clearing vectors, the counting identity behind (I.15), and the two closed forms of the distortion. The printed argument also leaves a step to be supplied: its final appeal to "the monotone selection theorem" needs the distortion comparison at every profile of the other banks. It is proved only when they all choose the same project, and it is false in general. The goal is nevertheless stated for least equilibria exactly as in the paper, and its formal proof has to bridge that gap. The milestones are true as stated.
Difficulty
The distortion of the ring is not a function of the number of failures alone. What a successful bank receives depends on the length of the run of failed banks immediately upstream of it, so the closed form needs an exact count of the binary strings with a given number of failures and a given initial run length. The comparison of the two distortions is not termwise either: the positive part sits inside a sum on the ring side and outside it on the complete side.
The obvious final step is to say that the distortion is larger in the complete network, and that a larger distortion raises the optimal risk exposure. That step does not go through as stated. The equilibrium comparison needs control of the best-response maps at every profile, while the distortion comparison holds only on the diagonal, where all other banks choose the same project. Some further structure of the two games is needed to restrict attention to that diagonal.
Formalization scope
Banks are Fin N with , and states are Fin N → Bool with true meaning success. The paper's general model is specialized to a regular network given by , which covers both networks of Definition 3. Every expectation is a finite sum over the states, so no measure theory is involved. The payment equilibrium is the greatest solution of the clearing system, because the paper asserts only generic uniqueness. Every bank's project lies in , and is a hypothesis of every statement.
The distortion milestones (2, 5 and 8) are stated at the constant profile in which every bank chooses the same , which is how the page's single reads. At , where every other bank fails, the printed ring binomial has lower index , and the weight is fixed explicitly to at . Proposition 4 is stated for least equilibria and weak inequality. It adds one hypothesis the page does not state, continuity of on , so that best responses and least equilibria exist. Without it the IsLeast hypotheses could be unsatisfiable and the goal vacuous.
Trivializing encodings are ruled out: is an actual solution of the clearing system, not a junk supremum, and the run length is only used in states where some bank succeeds.
A complete development needs Knaster–Tarski on the box , the clearing computations for the two networks, binomial identities, and a monotone comparative statics argument for the equilibria. Published Topkis results on supermodular games (existence of least equilibria, and monotonicity of least fixed points in a parameter) are included by reference as tools. The clearing and counting lemmas are reusable for the paper's other results on ring and complete networks. Proofs of any milestone, and of the goal, are welcome.
Not posed here: Proposition 1 (strategic complementarity in any network, a separate mission), Proposition 2 (existence), and the later comparative statics in the number of banks, central clearing and bailouts.
Selected references
- C. Shu, Endogenous Risk Exposure and Systemic Instability, Management Science (accepted manuscript, 17 Sep 2024). https://doi.org/10.1287/mnsc.2022.01519
- F. Allen and D. Gale, Financial Contagion, Journal of Political Economy 108(1), 2000. https://doi.org/10.1086/262109
- D. Acemoglu, A. Ozdaglar and A. Tahbaz-Salehi, Systemic Risk and Stability in Financial Networks, American Economic Review 105(2), 2015. https://doi.org/10.1257/aer.20130456
- L. Eisenberg and T. H. Noe, Systemic Risk in Financial Systems, Management Science 47(2), 2001. https://doi.org/10.1287/mnsc.47.2.236.9835
- D. M. Topkis, Supermodularity and Complementarity, Princeton University Press, 1998. https://doi.org/10.1515/9781400822539