How Does a Shock Propagate? A Model of Contagion in the Interbank Market Due to Financial Linkages

40 Pages Posted: 12 Mar 2005

See all articles by José-Luis Peydró

José-Luis Peydró

Imperial College London; Centre for Economic Policy Research (CEPR); Universitat Pompeu Fabra - Faculty of Economic and Business Sciences

Rajkamal Iyer

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Date Written: May 2005

Abstract

In a setting with multiple banks and differential information, we study how a shock propagates in the banking system due to strategic interactions between banks' managers and depositors. We construct a model in which a bank faces an exogenous shock and study the transmission of this shock in the interbank market due to financial linkages. We uniquely determine the unfolding of the financial crisis in equilibrium. Firstly, we show that an initial shock to a bank is transmitted to the banking system, thus increasing the financial fragility. The more interesting part of our analysis is, however, the role played by creditor banks in the transmission of the shock. We show that, under certain circumstances, creditor banks increase the fragility of borrower banks by unwinding their claims to distance themselves from the line of contagion. Furthermore, our model predicts that even when creditor banks do not directly play an important role on the financial distress of their borrower banks, they amplify the sensitivity of the initial shock on their borrower banks. Our model shows that not only does the interbank market transmit shocks - and acts as a channel for contagion - but also that the endogenous liquidity in the interbank market can be reduced after the initial shock, thereby increasing the fragility of the whole system over and above the initial shock.

Keywords: Bank runs, coordination risk, financial crisis, contagion, systemic risk, global games.

JEL Classification: G21, G28

Suggested Citation

Peydro, Jose-Luis and Iyer, Rajkamal, How Does a Shock Propagate? A Model of Contagion in the Interbank Market Due to Financial Linkages (May 2005). Available at SSRN: https://ssrn.com/abstract=675743 or http://dx.doi.org/10.2139/ssrn.675743

Jose-Luis Peydro (Contact Author)

Imperial College London ( email )

South Kensington Campus
Exhibition Road
London, Greater London SW7 2AZ
United Kingdom

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Universitat Pompeu Fabra - Faculty of Economic and Business Sciences ( email )

Ramon Trias Fargas 25-27
Barcelona, Barcelona 08005
Spain
(+34) 93 542 1756 (Phone)
(+34) 93 542 1746 (Fax)

HOME PAGE: http://https://sites.google.com/site/joseluispeydroswebpage/

Rajkamal Iyer

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-416
Cambridge, MA 02142
United States

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