Networks in Financial Markets: Liquidity, Interbank Markets and Depositors

Abstract:     
We study the microstructure of financial contagion and in particular, the mechanisms of transmission/ amplification of idiosyncratic shocks through the financial network. A key result of the literature on financial complexity is that networks have the potential to become instable. A small liquidity preference shock can spread by contagion through the economy, resulting in multiple equilibria. However, multiplicity of equilibria is not unavoidable. We study in detail under what conditions this multiplicity can be ruled out and a unique solution can be obtained.

The paper makes a number of contributions. First, by studying the link between interbank markets and information, we address the mechanisms through which banks set the optimal level of excess reserves. More specifically, under what conditions precautionary liquidity hoarding can spread to the financial system, given a shock to one bank. Distinguishing from the literature, we do not assume aversion to uncertainty or worst case scenario. Instead, we obtain them as an endogenous response of banks, under certain conditions.

Second, we motivate multiplicity of equilibria by focusing on feedback effects between banks interlinked in a financial network. Third, we apply global games to solve the equilibrium indeterminacy in the Diamond and Dybvig (1983) and Allen and Gale (2000)'s environment. By introducing heterogeneous information set for banks, we find an endogenously determined single trigger strategy, thus obtaining the jump in agents' decision according to fundamentals, typical of every application of this tool.

Number of Pages in PDF File: 17

Keywords: Contagion, financial complexity, network uncertainty

JEL Classification: G01, G15, G21

working papers series