Bank Networks: Contagion, Systemic Risk and Prudential Policy
SAFE Working Paper No. 87
43 Pages Posted: 3 Mar 2015 Last revised: 18 Jul 2015
Date Written: July 2015
We present a network model of the interbank market in which optimizing risk averse banks lend to each other and invest in non-liquid assets. Market clearing takes place through a tâtonnement process which yields the equilibrium price, while traded quantities are determined by means of a matching algorithm. Contagion occurs through liquidity hoarding, interbank interlinkages and fire sale externalities. The resulting network configuration exhibits a coreperiphery structure, dis-assortative behavior and low density. Within this framework we analyze the effects of prudential policies on the stability/efficiency trade-off. Liquidity requirements unequivocally decrease systemic risk but at the cost of lower efficiency (measured by aggregate investment in non-liquid assets). Equity requirements tend to reduce risk (hence increase stability) without reducing significantly overall investment.
Keywords: banking networks, systemic risk, contagion, fire sales, prudential regulation
JEL Classification: D85, G21, G28, C63, L14
Suggested Citation: Suggested Citation