IDEAS home Printed from https://ideas.repec.org/p/boe/boeewp/0833.html
   My bibliography  Save this paper

A structural model of interbank network formation and contagion

Author

Listed:
  • Coen, Patrick

    (London School of Economics)

  • Coen, Jamie

    (London School of Economics and Bank of England)

Abstract

The interbank network, in which banks compete with each other to supply and demand differentiated financial products, fulfils an important function but may also result in risk propagation. We examine this trade-off by setting out a model in which banks form interbank network links endogenously, taking into account the effect of links on default risk. We estimate this model based on novel, granular data on aggregate exposures between banks. We find that the decentralised interbank market is not efficient: a social planner would be able to increase surplus on the interbank market by 13% without increasing mean bank default risk or decrease mean bank default risk by 4% without decreasing interbank surplus. We then propose two novel regulatory interventions (caps on aggregate exposures and pairwise capital requirements) that result in efficiency gains.

Suggested Citation

  • Coen, Patrick & Coen, Jamie, 2019. "A structural model of interbank network formation and contagion," Bank of England working papers 833, Bank of England.
    • Handle: RePEc:boe:boeewp:0833
    as

    Download full text from publisher

    File URL: https://www.bankofengland.co.uk/-/media/boe/files/working-paper/2019/a-structural-model-of-interbank-network-formation-and-contagion.pdf
    File Function: Full text
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. van Horen, Neeltje & Kotidis, Antonios, 2018. "Repo market functioning: The role of capital regulation," CEPR Discussion Papers 13090, C.E.P.R. Discussion Papers.
    2. Daron Acemoglu & Asuman Ozdaglar & Alireza Tahbaz-Salehi, 2015. "Systemic Risk and Stability in Financial Networks," American Economic Review, American Economic Association, vol. 105(2), pages 564-608, February.
    3. Iyer, Rajkamal & Peydró, José-Luis, 2011. "Interbank contagion at work: Evidence from a natural experiment," EconStor Open Access Articles and Book Chapters, ZBW - Leibniz Information Centre for Economics, vol. 24(4), pages 1337-1377.
    4. Denbee, Edward & Julliard, Christian & Li, Ye & Yuan, Kathy, 2021. "Network risk and key players: A structural analysis of interbank liquidity," Journal of Financial Economics, Elsevier, vol. 141(3), pages 831-859.
    5. Gofman, Michael, 2017. "Efficiency and stability of a financial architecture with too-interconnected-to-fail institutions," Journal of Financial Economics, Elsevier, vol. 124(1), pages 113-146.
    6. Coralio Ballester & Antoni Calvó-Armengol & Yves Zenou, 2006. "Who's Who in Networks. Wanted: The Key Player," Econometrica, Econometric Society, vol. 74(5), pages 1403-1417, September.
    7. Tobias Adrian & Nina Boyarchenko & Or Shachar, 2017. "Dealer Balance Sheets and Corporate Bond Liquidity Provision," Liberty Street Economics 20170524, Federal Reserve Bank of New York.
    8. Robin Greenwood & Samuel G. Hanson & Jeremy C. Stein & Adi Sunderam, 2017. "Strengthening and Streamlining Bank Capital Regulation," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 48(2 (Fall)), pages 479-565.
    9. Franklin Allen & Ana Babus & Elena Carletti, 2009. "Financial Crises: Theory and Evidence," Annual Review of Financial Economics, Annual Reviews, vol. 1(1), pages 97-116, November.
    10. Matthew Elliott & Benjamin Golub & Matthew O. Jackson, 2014. "Financial Networks and Contagion," American Economic Review, American Economic Association, vol. 104(10), pages 3115-3153, October.
    11. Paul J.J. Welfens & Cillian Ryan (ed.), 2011. "Financial Market Integration and Growth," Springer Books, Springer, number 978-3-642-16274-9, December.
    12. Ana Babus, 2016. "The formation of financial networks," RAND Journal of Economics, RAND Corporation, vol. 47(2), pages 239-272, May.
    13. Blasques, Francisco & Bräuning, Falk & Lelyveld, Iman van, 2018. "A dynamic network model of the unsecured interbank lending market," Journal of Economic Dynamics and Control, Elsevier, vol. 90(C), pages 310-342.
    14. Glasserman, Paul & Young, H. Peyton, 2015. "How likely is contagion in financial networks?," Journal of Banking & Finance, Elsevier, vol. 50(C), pages 383-399.
    15. Batiz-Zuk, Enrique & López-Gallo, Fabrizio & Martínez-Jaramillo, Serafín & Solórzano-Margain, Juan Pablo, 2016. "Calibrating limits for large interbank exposures from a system-wide perspective," Journal of Financial Stability, Elsevier, vol. 27(C), pages 198-216.
    16. Jason Allen & Ali Hortaçsu & Jakub Kastl, 2011. "Analyzing Default Risk and Liquidity Demand during a Financial Crisis: The Case of Canada," Staff Working Papers 11-17, Bank of Canada.
    17. Adrian, Tobias & Boyarchenko, Nina & Shachar, Or, 2017. "Dealer balance sheets and bond liquidity provision," Journal of Monetary Economics, Elsevier, vol. 89(C), pages 92-109.
    18. Paul Glasserman & Peyton Young, 2015. "Contagion in Financial Networks," Economics Series Working Papers 764, University of Oxford, Department of Economics.
    19. Hendrik Bessembinder & Stacey Jacobsen & William Maxwell & Kumar Venkataraman, 2018. "Capital Commitment and Illiquidity in Corporate Bonds," Journal of Finance, American Finance Association, vol. 73(4), pages 1615-1661, August.
    20. Malcolm Baker & Jeffrey Wurgler, 2015. "Do Strict Capital Requirements Raise the Cost of Capital? Bank Regulation, Capital Structure, and the Low-Risk Anomaly," American Economic Review, American Economic Association, vol. 105(5), pages 315-320, May.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Elliott, Matthew & Georg, Co-Pierre & Hazell, Jonathon, 2021. "Systemic risk shifting in financial networks," Journal of Economic Theory, Elsevier, vol. 191(C).
    2. Antonio Cabrales & Piero Gottardi & Fernando Vega-Redondo, 2017. "Risk Sharing and Contagion in Networks," The Review of Financial Studies, Society for Financial Studies, vol. 30(9), pages 3086-3127.
    3. Elliott, Matthew & Georg, Co-Pierre & Hazell, Jonathon, 2021. "Systemic risk shifting in financial networks," LSE Research Online Documents on Economics 123924, London School of Economics and Political Science, LSE Library.
    4. Allen, Franklin & Gu, Xian, 2018. "The Interplay between Regulations and Financial Stability," CEPR Discussion Papers 12862, C.E.P.R. Discussion Papers.
    5. Franklin Allen & Xian Gu, 2018. "The Interplay between Regulations and Financial Stability," Journal of Financial Services Research, Springer;Western Finance Association, vol. 53(2), pages 233-248, June.
    6. Elliott, M. & Georg, C-P. & Hazell, J., 2020. "Systemic Risk-Shifting in Financial Networks," Cambridge Working Papers in Economics 2068, Faculty of Economics, University of Cambridge.
    7. Zhang, Xiaoyuan & Zhang, Tianqi, 2022. "Dynamic credit contagion and aggregate loss in networks," The North American Journal of Economics and Finance, Elsevier, vol. 62(C).
    8. Gofman, Michael, 2017. "Efficiency and stability of a financial architecture with too-interconnected-to-fail institutions," Journal of Financial Economics, Elsevier, vol. 124(1), pages 113-146.
    9. Peydró, José-Luis & Jiménez, Gabriel & Kenan, Huremovic & Moral-Benito, Enrique & Vega-Redondo, Fernando, 2020. "Production and financial networks in interplay: Crisis evidence from supplier-customer and credit registers," CEPR Discussion Papers 15277, C.E.P.R. Discussion Papers.
    10. Gabrielle Demange, 2018. "Contagion in Financial Networks: A Threat Index," Management Science, INFORMS, vol. 64(2), pages 955-970, February.
    11. Li, Fei & Kang, Hao & Xu, Jingfeng, 2022. "Financial stability and network complexity: A random matrix approach," International Review of Economics & Finance, Elsevier, vol. 80(C), pages 177-185.
    12. Daron Acemoglu & Asuman Ozdaglar & Alireza Tahbaz-Salehi, 2015. "Networks, Shocks, and Systemic Risk," NBER Working Papers 20931, National Bureau of Economic Research, Inc.
    13. Ebrahimi Kahou, Mahdi & Lehar, Alfred, 2017. "Macroprudential policy: A review," Journal of Financial Stability, Elsevier, vol. 29(C), pages 92-105.
    14. Jin-Wook Chang, 2019. "Collateralized Debt Networks with Lender Default," Finance and Economics Discussion Series 2019-083, Board of Governors of the Federal Reserve System (U.S.).
    15. Spiros Bougheas & Adam Hal Spencer, 2022. "Fire sales and ex ante valuation of systemic risk: A financial equilibrium networks approach," Discussion Papers 2022/04, University of Nottingham, Centre for Finance, Credit and Macroeconomics (CFCM).
    16. Jose Arreola Hernandez & Sang Hoon Kang & Ron P. McIver & Seong-Min Yoon, 2021. "Network Interdependence and Optimization of Bank Portfolios from Developed and Emerging Asia Pacific Countries," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 28(4), pages 613-647, December.
    17. Chang, Briana & Zhang, Shengxing, 2015. "Endogenous market making and network formation," LSE Research Online Documents on Economics 65105, London School of Economics and Political Science, LSE Library.
    18. Kruttli, Mathias S. & Monin, Phillip J. & Watugala, Sumudu W., 2022. "The life of the counterparty: Shock propagation in hedge fund-prime broker credit networks," Journal of Financial Economics, Elsevier, vol. 146(3), pages 965-988.
    19. Andrew Ellul & Dasol Kim, 2021. "Counterparty Choice, Bank Interconnectedness, and Systemic Risk," Working Papers 21-03, Office of Financial Research, US Department of the Treasury.
    20. Linardi, Fernando & Diks, Cees & van der Leij, Marco & Lazier, Iuri, 2020. "Dynamic interbank network analysis using latent space models," Journal of Economic Dynamics and Control, Elsevier, vol. 112(C).

    More about this item

    Keywords

    Contagion; systemic risk; interbank network; network formation;
    All these keywords.

    JEL classification:

    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • L13 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Oligopoly and Other Imperfect Markets
    • L51 - Industrial Organization - - Regulation and Industrial Policy - - - Economics of Regulation

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:boe:boeewp:0833. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Digital Media Team (email available below). General contact details of provider: https://edirc.repec.org/data/boegvuk.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.