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Network models and financial stability

  • Nier, Erlend
  • Yang, Jing
  • Yorulmazer, Tanju
  • Alentorn, Amadeo

Systemic risk is a key concern for central banks charged with safeguarding overall financial stability. In this paper we investigate how systemic risk is affected by the structure of the financial system. We construct banking systems that are composed of a number of banks that are connected by interbank linkages. We then vary the key parameters that define the structure of the financial system - including its level of capitalisation, the degree to which banks are connected, the size of interbank exposures and the degree of concentration of the system - and analyse the influence of these parameters on the likelihood of contagious (knock-on) defaults. First, we find that the better capitalised banks are, the more resilient is the banking system against contagious defaults and this effect is non-linear. Second, the effect of the degree of connectivity is non-monotonic, that is, initially a small increase in connectivity increases the contagion effect; but after a certain threshold value, connectivity improves the ability of a banking system to absorb shocks. Third, the size of interbank liabilities tends to increase the risk of knock-on default, even if banks hold capital against such exposures. Fourth, more concentrated banking systems are shown to be prone to larger systemic risk, all else equal. In an extension to the main analysis we study how liquidity effects interact with banking structure to produce a greater chance of systemic breakdown. We finally consider how the risk of contagion might depend on the degree of asymmetry (tiering) inherent in the structure of the banking system. A number of our results have important implications for public policy, which this paper also draws out.

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Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 31 (2007)
Issue (Month): 6 (June)
Pages: 2033-2060

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Handle: RePEc:eee:dyncon:v:31:y:2007:i:6:p:2033-2060
Contact details of provider: Web page: http://www.elsevier.com/locate/jedc

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  1. Glenn Hoggarth & Ricardo Reis & Victoria Saporta, 2001. "Costs of banking system instability: some empirical evidence," Bank of England working papers 144, Bank of England.
  2. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
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  7. Helmut Elsinger & Alfred Lehar & Martin Summer, 2002. "Risk Assessment for Banking Systems," Working Papers 79, Oesterreichische Nationalbank (Austrian Central Bank).
  8. Iman van Lelyveld & Franka Liedorp, 2006. "Interbank Contagion in the Dutch Banking Sector: A Sensitivity Analysis," International Journal of Central Banking, International Journal of Central Banking, vol. 2(2), May.
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  10. Yehning Chen, 1999. "Banking Panics: The Role of the First-Come, First-Served Rule and Information Externalities," Journal of Political Economy, University of Chicago Press, vol. 107(5), pages 946-968, October.
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  13. Michael Boss & Helmut Elsinger & Martin Summer & Stefan Thurner, 2004. "An Empirical Analysis of the Network Structure of the Austrian Interbank Market," Financial Stability Report, Oesterreichische Nationalbank (Austrian Central Bank), issue 7, pages 77-87.
  14. Flannery, Mark J, 1996. "Financial Crises, Payment System Problems, and Discount Window Lending," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(4), pages 804-24, November.
  15. Upper, Christian & Worms, Andreas, 2002. "Estimating Bilateral Exposures in the German Interbank Market: Is there a Danger of Contagion?," Discussion Paper Series 1: Economic Studies 2002,09, Deutsche Bundesbank, Research Centre.
  16. 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), vol. 134(IV), pages 685-704, December.
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