Contagion in a Network of Heterogeneous Banks

Abstract

We consider a financial network where banks are heterogeneous in scales and each bank has only local knowledge regarding the network. Each bank must make counterparty and portfolio decisions while facing uncertainty regarding the network structure. Such uncertainty plays an important role in banks' risk management practices in minimizing the effect of exogenous liquidity shocks and hedging against possible fire-sale in asset markets. This results in an endogenous core-periphery structure which is optimal in mitigating financial contagion yet concentrates systemic risk at the core of big banks.

Keywords: Financial networks, Contagion, Heterogeneous banks, Core-Periphery structure, Network externality

JEL Classification: G01, G22, G28