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Bank Networks: Contagion, Systemic Risk and Prudential Policy

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  • Aldasoro, Iñaki
  • Delli Gatti, Domenico
  • Faia, Ester

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 a matching algorithm. Contagion occurs through liquidity hoarding, interbank interlinkages and fire sale externalities. The resulting network configuration exhibits a core-periphery structure, dis-assortative behavior and low density. Within this framework we analyze the effects 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 tend to reduce risk (hence increasestability) without reducing significantly overall investment.

Suggested Citation

  • Aldasoro, Iñaki & Delli Gatti, Domenico & Faia, Ester, 2015. "Bank Networks: Contagion, Systemic Risk and Prudential Policy," CEPR Discussion Papers 10540, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:10540
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    More about this item

    Keywords

    banking networks; contagion; fire sales; prudential regulation; systemic risk;
    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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