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By applying models of social and economic networks to financial institutions, the purpose of this paper is to address the issues of how policy makers can promote financial network stability and social efficiency.

The authors characterize the decentralized network formation of financial institutions in three stages through which institutions choose to become member banks connected to a central bank, bank-holding company subsidiaries or non-banks. Financial institutions choose one of the three roles in an endogenous process by considering the effects of sharing shocks among the members of the network. In the model, there is a social-welfare-maximizing government regulator at the center of the network.

The authors show that the stable equilibrium network is not always the efficient network, so the central authority must use policy instruments to ensure that the stable equilibrium network is as close as possible to the efficient network.

To obtain the theoretical results, the authors make assumptions about the utility function and risk aversion of a financial institution, as well as about the costs of network formation. These assumptions might need to be relaxed to bring the model closer to real-world institutions.

The results suggest that regulators must try to set their policy variables to make the efficient network as close as possible to the stable network.

The contribution is to incorporate concepts from social network theory into the modeling of financial networks. The results may be of use to regulators in maintaining the stability of the financial system.