Bank Diversity and Financial Contagion

This paper analyzes financial contagion in a banking system where banks are linked by interbank claims and common assets. We find that asset commonality makes banking systems more vulnerable to idiosyncratic shocks and helps to determine which interbank network structures are resistant to contagion. When the degree of commonality is homogeneous across banks, the most resilient structure is the complete interbank network in which each bank borrows evenly from all the others. However, when the bank most exposed to the defaulting bank is not the one whose portfolio is most similar to it, incomplete interbank networks are more resilient than complete. We also show that the degree and variability of asset commonality between banks and the way this intertwines with the cross-holdings of interbank deposits have important implications for macroprudential regulation.