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The Formation of Financial Networks

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  • Ana Babus

    ()
    (Erasmus Universiteit Rotterdam)

Abstract

Modern banking systems are highly interconnected. Despite their various benefits, the linkages that exist between banks carry the risk of contagion. In this paper we investigate how banks decide on direct balance sheet linkages and the implications for contagion risk. In particular, we model a network formation process in the banking system. The trade-off between the gains and the risks of being connected shapes banks ’incentives to form links. We show that banks manage to form networks that are resilient to contagion. Thus, in an equilibrium network, the probability of contagion is virtually 0.

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Bibliographic Info

Paper provided by Tinbergen Institute in its series Tinbergen Institute Discussion Papers with number 06-093/2.

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Date of creation: 23 Oct 2006
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Handle: RePEc:dgr:uvatin:20060093

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Web page: http://www.tinbergen.nl

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Keywords: financial stability; network formation; contagion risk;

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  9. Upper, Christian & Worms, Andreas, 2004. "Estimating bilateral exposures in the German interbank market: Is there a danger of contagion?," European Economic Review, Elsevier, Elsevier, vol. 48(4), pages 827-849, August.
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  12. George Sheldon & Martin Maurer, 1998. "Interbank Lending and Systemic Risk: An Empirical Analysis for Switzerland," Swiss Journal of Economics and Statistics (SJES), Swiss Society of Economics and Statistics (SSES), Swiss Society of Economics and Statistics (SSES), vol. 134(IV), pages 685-704, December.
  13. Bhaskar Dutta & Sayantan Ghosal & Debraj Ray, 2004. "Farsighted Network Formation," Working papers, Centre for Development Economics, Delhi School of Economics 122, Centre for Development Economics, Delhi School of Economics.
  14. Franklin Allen & Douglas Gale, 1998. "Financial Contagion Journal of Political Economy," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 98-31, Wharton School Center for Financial Institutions, University of Pennsylvania.
  15. Hans Degryse & Grégory Nguyen, 2004. "Interbank exposures: an empirical examination of systemic risk in the Belgian banking system," Working Paper Research, National Bank of Belgium 43, National Bank of Belgium.
  16. Furfine, Craig H, 2003. " Interbank Exposures: Quantifying the Risk of Contagion," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 35(1), pages 111-28, February.
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