When banks choose similar investment strategies the financial system becomes
vulnerable to common shocks. We model a simple financial system in which banks
decide about their investment strategy based on a private belief about the
state of the world and a social belief formed from observing the actions of
peers. Observing a larger group of peers conveys more information and thus
leads to a stronger social belief. Extending the standard model of Bayesian
updating in social networks, we show that the probability that banks
synchronize their investment strategy on a state non-matching action critically
depends on the weighting between private and social belief. This effect is
alleviated when banks choose their peers endogenously in a network formation
process, internalizing the externalities arising from social learning.Comment: 41 pages, 10 figures, Journal of Banking & Finance 201
