A Network Theory of Safety Premium

74 Pages Posted: 2 Jul 2021

See all articles by Zhongjie Fan

Zhongjie Fan

Tsinghua University - Tsinghua University School of Economics and Management

Ping He

Tsinghua University, SEM

Zehao Liu

School of Finance, Renmin University of China

Date Written: June 21, 2021

Abstract

Interconnected banks are prone to the propagation of negative shocks. In a network with banks borrowing from each other using collateral, the risk of financial contagion leads to the emergence of multiple equilibria, featuring different sizes of loans and collateral haircuts. Safe assets are traded at a premium because safe collateral helps the economy to deter the propagation of negative shocks. A small decrease in collateral quality, increasing the contagion risk, might lead to an equilibrium jump to one with a smaller amount of interbank lending, along with which the safety premium will suddenly increase.

Keywords: Safety Premium, Network, Financial Contagion, Collateral, Multiple Equilibria

JEL Classification: D85, E44, G01, G21, L14

Suggested Citation

Fan, Zhongjie and He, Ping and Liu, Zehao, A Network Theory of Safety Premium (June 21, 2021). Available at SSRN: https://ssrn.com/abstract=3870960 or http://dx.doi.org/10.2139/ssrn.3870960

Zhongjie Fan

Tsinghua University - Tsinghua University School of Economics and Management ( email )

Beijing
China

Ping He

Tsinghua University, SEM ( email )

Beijing, 100084
China
8610-62795754 (Phone)
8610-62784554 (Fax)

HOME PAGE: http://www.sem.tsinghua.edu.cn/en/heping

Zehao Liu (Contact Author)

School of Finance, Renmin University of China ( email )

Ming De Main Building
Renmin University of China
Beijing, Beijing 100872
China

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