Financial Contagion in the Laboratory: Does Network Structure Matter?

Abstract

We design and report on the first laboratory experiment exploring the role of interbank network structure and premature liquidation costs for the likelihood of a financial contagion. The laboratory provides the control necessary to understand the role played by interbank network configurations and liquidation costs for the fragility of the financial system. Specifically, we study the likelihood of financial contagion in complete and incomplete networks of banks that are linked in terms of interbank deposits as in the model of Allen and Gale (2000) and we further vary the cost of premature liquidation. Subjects play the role of depositors who must decide whether or not to withdraw their funds from their interconnected banks. We find that when liquidation costs are high, a complete network structure enabling efficient risk sharing is significantly less vulnerable to financial contagions than an incomplete network structure. However, when liquidation costs are low, network structure does not matter as much for the frequency of financial contagions. We conclude that low liquidation costs or a more complete network structure can be viewed as substitutes for reducing the frequency of financial contagions.

Keywords: Contagion, Networks, Experiments, Bank Runs, Interbank Deposits, Financial Fragility

JEL Classification: C92, E44, G21