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Bank networks: contagion, systemic risk and prudential policy

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  • Iñaki Aldasoro
  • Domenico Delli Gatti
  • Ester Faia

Abstract

We present a network model of the interbank market in which optimizing risk averse banks lend to each other and invest in non-liquid assets. Market clearing takes place through a tâtonnement process which yields the equilibrium price, while traded quantities are determined by means of an assortative matching process. Contagion occurs through liquidity hoarding, interbank interlinkages and fire sale externalities. The resulting network configuration exhibits a core-periphery structure, disassortative behavior and low density. Within this framework we analyse the effects of a stylized set of prudential policies on the stability/efficiency trade-off. Liquidity requirements unequivocally decrease systemic risk, but at the cost of lower efficiency (measured by aggregate investment in non-liquid assets). Equity requirements also tend to reduce risk (hence increase stability), though without reducing significantly overall investment. On this basis, our results provide general support for the Basel III approach based on complementary regulatory metrics.

Suggested Citation

  • Iñaki Aldasoro & Domenico Delli Gatti & Ester Faia, 2016. "Bank networks: contagion, systemic risk and prudential policy," BIS Working Papers 597, Bank for International Settlements.
  • Handle: RePEc:bis:biswps:597
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    More about this item

    Keywords

    Banking networks; systemic risk; contagion; fire sales; prudential regulation;
    All these keywords.

    JEL classification:

    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • D85 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Network Formation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation

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