  Financial networks help firms manage risk but also enable financial shocks to
spread. Despite their importance, existing models of financial networks have
several limitations. Prior works often consider a static network with a simple
structure (e.g., a ring) or a model that assumes conditional independence
between edges. We propose a new model where the network emerges from
interactions between heterogeneous utility-maximizing firms. Edges correspond
to contract agreements between pairs of firms, with the contract size being the
edge weight. We show that, almost always, there is a unique "stable network."
All edge weights in this stable network depend on all firms' beliefs.
Furthermore, firms can find the stable network via iterative pairwise
negotiations. When beliefs change, the stable network changes. We show that
under realistic settings, a regulator cannot pin down the changed beliefs that
caused the network changes. Also, each firm can use its view of the network to
inform its beliefs. For instance, it can detect outlier firms whose beliefs
deviate from their peers. But it cannot identify the deviant belief: increased
risk-seeking is indistinguishable from increased expected profits. Seemingly
minor news may settle the dilemma, triggering significant changes in the
network.
