Systemic Risk and Network Formation in the Interbank Market

48 Pages Posted: 6 Apr 2011

See all articles by Ethan Cohen-Cole

Ethan Cohen-Cole

Econ One Research

Eleonora Patacchini

Einaudi Institute for Economics and Finance (EIEF) ; IZA Institute of Labor Economics

Yves Zenou

Monash University - Department of Economics; Stockholm University; Research Institute of Industrial Economics (IUI); IZA Institute of Labor Economics; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: December 1, 2010

Abstract

We propose a novel mechanism to facilitate understanding of systemic risk in financial markets. The literature on systemic risk has focused on two mechanisms, common shocks and domino-like sequential default. Our approach is a formal model that provides an intellectual combination of the two by looking at how shocks propagate through a network of interconnected banks. Transmission in our model is not based on default. Instead, we provide a simple microfoundation of banks’ profitability based on classic competition incentives. As competitors’ lending quantities change, both for closely connected ones and the whole market, banks adjust their own lending decisions as a result, generating a ‘transmission’ of shocks through the system. Our approach permits us to measure both the degree that shocks are amplified by the network structure and the manner in which losses and gains are shared. We provide a unique equilibrium characterization of a static model, and embed this model into a full dynamic model of network formation with n agents. Because we have an explicit characterization of equilibrium behavior, we have a tractable way to bring the model to the data. Indeed, our measures of systemic risk capture the propagation of shocks in a wide variety of contexts; that is, it can explain the pattern of behavior both in good times as well as in crisis.

Keywords: Financial networks, interbank lending, interconnections, network centrality, spatial autoregressive models

JEL Classification: G10, C21

Suggested Citation

Cohen-Cole, Ethan and Patacchini, Eleonora and Zenou, Yves, Systemic Risk and Network Formation in the Interbank Market (December 1, 2010). CAREFIN Research Paper No. 25/2010. Available at SSRN: https://ssrn.com/abstract=1799925

Ethan Cohen-Cole (Contact Author)

Econ One Research ( email )

United States

Eleonora Patacchini

Einaudi Institute for Economics and Finance (EIEF) ( email )

Via Due Macelli, 73
Rome, 00187
Italy

IZA Institute of Labor Economics ( email )

P.O. Box 7240
Bonn, D-53072
Germany

Yves Zenou

Monash University - Department of Economics ( email )

Australia

Stockholm University ( email )

Universitetsvägen 10
Stockholm, Stockholm SE-106 91
Sweden

Research Institute of Industrial Economics (IUI) ( email )

P.O. Box 5501
S-114 85 Stockholm
Sweden

IZA Institute of Labor Economics

P.O. Box 7240
Bonn, D-53072
Germany

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Register to save articles to
your library

Register

Paper statistics

Downloads
551
Abstract Views
2,255
rank
48,459
PlumX Metrics