A Structural Model of Interbank Network Formation and Contagion

58 Pages Posted: 12 Oct 2019

See all articles by Patrick Coen

Patrick Coen

London School of Economics & Political Science (LSE) - London School of Economics

Jamie Coen

Bank of England

Date Written: October 11, 2019

Abstract

The interbank network, in which banks compete with each other to supply and demand differentiated financial products, fulfils an important function but may also result in risk propagation. We examine this trade-off by setting out a model in which banks form interbank network links endogenously, taking into account the effect of links on default risk. We estimate this model based on novel, granular data on aggregate exposures between banks. We find that the decentralised interbank market is not efficient: a social planner would be able to increase surplus on the interbank market by 13% without increasing mean bank default risk or decrease mean bank default risk by 4% without decreasing interbank surplus. We then propose two novel regulatory interventions (caps on aggregate exposures and pairwise capital requirements) that result in efficiency gains.

Keywords: contagion, systemic risk, interbank network, network formation

JEL Classification: L13, L51, G28, G18

Suggested Citation

Coen, Patrick and Coen, Jamie, A Structural Model of Interbank Network Formation and Contagion (October 11, 2019). Bank of England Working Paper No. 833, October 2019. Available at SSRN: https://ssrn.com/abstract=3468304 or http://dx.doi.org/10.2139/ssrn.3468304

Patrick Coen

London School of Economics & Political Science (LSE) - London School of Economics ( email )

United Kingdom

Jamie Coen (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

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