Interconnectedness Among Banks, Financial Stability, and Bank Capital Regulation

29 Pages Posted: 16 Nov 2016

See all articles by Yehning Chen

Yehning Chen

National Taiwan University

Iftekhar Hasan

Fordham University - Gabelli School of Business; Bank of Finland

Date Written: November 2016

Abstract

This paper proposes that whether interconnectedness among banks leads to financial instability depends on banks’ leverage decisions. It extends the network model in Allen et al. (2012) to study the relationship between interconnectedness and the banks’ failure probability. In the model, banks adopt the Value-at-Risk rule to make the capital structure decisions and the risk of contagion is neglected. The paper finds that interconnectedness may either increase or decrease the banks’ failure probability. It also shows that interconnection is more harmful when banks are more over-optimistic about their prospects, and that financial integration may hurt financial stability. In addition, the adverse impact of interconnectedness on the banks’ failure probability can be alleviated if bank capital regulation is properly designed. This paper supports the conclusion in Allen and Gale (2000) that a complete financial system in which each bank is connected to all the other banks is superior to incomplete ones in which banks are connected to only a part of other banks.

Keywords: financial network, contagion, interconnectedness, diversification, bank capital regulation

JEL Classification: G01, G21

Suggested Citation

Chen, Yehning and Hasan, Iftekhar, Interconnectedness Among Banks, Financial Stability, and Bank Capital Regulation (November 2016). BAFFI CAREFIN Centre Research Paper No. 2016-43. Available at SSRN: https://ssrn.com/abstract=2869823 or http://dx.doi.org/10.2139/ssrn.2869823

Yehning Chen

National Taiwan University ( email )

1 Sec. 4, Roosevelt Road
Taipei, 106
Taiwan

Iftekhar Hasan (Contact Author)

Fordham University - Gabelli School of Business ( email )

Rose Hill Campus Bronx
New York, NY 10458
United States

Bank of Finland ( email )

P.O. Box 160
Helsinki 00101
Finland

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