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Systemic Risk and Network Formation in the Interbank Market

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Abstract

We propose a novel mechanism to facilitate understanding of systemic risk in financial markets. The literature on systemic risk has focused on two mechanisms, common shocks and domino-like sequential default. Our approach is a formal model that provides an intellectual combination of the two by looking at how shocks propagate through a network of interconnected banks. Transmission in our model is not based on default. Instead, we provide a simple microfoundation of banks’ profitability based on classic competition incentives. As competitors lending quantities change, both for closely connected ones and the whole market, banks adjust their own lending decisions as a result, generating a ‘transmission’ of shocks through the system. We provide a unique equilibrium characterization of a static model, and embed this model into a full dynamic model of network formation with n agents. Because we have an explicit characterization of equilibrium behavior, we have a tractable way to bring the model to the data. Indeed, our measures of systemic risk capture the propagation of shocks in a wide variety of contexts; that is, it can explain the pattern of behavior both in good times as well as in crisis.

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  • Cohen-Cole, Ethan & Patacchini, Eleonora & Zenou, Yves, 2011. "Systemic Risk and Network Formation in the Interbank Market," Research Papers in Economics 2011:6, Stockholm University, Department of Economics.
  • Handle: RePEc:hhs:sunrpe:2011_0006
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    Cited by:

    1. in 't Veld, Daan & van der Leij, Marco & Hommes, Cars, 2020. "The formation of a core-periphery structure in heterogeneous financial networks," Journal of Economic Dynamics and Control, Elsevier, vol. 119(C).
    2. Grzegorz Haᴌaj & Christoffer Kok, 2015. "Modelling the emergence of the interbank networks," Quantitative Finance, Taylor & Francis Journals, vol. 15(4), pages 653-671, April.
    3. Affinito, Massimiliano & Franco Pozzolo, Alberto, 2017. "The interbank network across the global financial crisis: Evidence from Italy," Journal of Banking & Finance, Elsevier, vol. 80(C), pages 90-107.
    4. Jackson, Matthew O. & Zenou, Yves, 2015. "Games on Networks," Handbook of Game Theory with Economic Applications,, Elsevier.
    5. Sophie Béreau & Nicolas Debarsy & Cyrille Dossougoin & Jean-Yves Gnabo, 2022. "Contagion in the Banking Industry: a Robust-to-Endogeneity Analysis," Working Papers halshs-03513049, HAL.
    6. Liu, Xiaodong & Patacchini, Eleonora & Zenou, Yves & Lee, Lung-Fei, 2011. "Criminal Networks: Who is the Key Player?," Research Papers in Economics 2011:7, Stockholm University, Department of Economics.
    7. Blocher, Jesse, 2016. "Network externalities in mutual funds," Journal of Financial Markets, Elsevier, vol. 30(C), pages 1-26.
    8. in ’t Veld, Daan & van Lelyveld, Iman, 2014. "Finding the core: Network structure in interbank markets," Journal of Banking & Finance, Elsevier, vol. 49(C), pages 27-40.
    9. , D. & Tessone, Claudio J. & ,, 2014. "Nestedness in networks: A theoretical model and some applications," Theoretical Economics, Econometric Society, vol. 9(3), September.
    10. Tonzer, Lena, 2015. "Cross-border interbank networks, banking risk and contagion," Journal of Financial Stability, Elsevier, vol. 18(C), pages 19-32.
    11. Shouwei Li & Jianmin He, 2012. "The Impact Of Bank Activities On Contagion Risk In Interbank Networks," Advances in Complex Systems (ACS), World Scientific Publishing Co. Pte. Ltd., vol. 15(supp0), pages 1-20.
    12. Yerali Gandica & Marco Valerio Geraci & Sophie Béreau & Jean-Yves Gnabo, 2018. "Fragmentation, integration and macroprudential surveillance of the US financial industry: Insights from network science," PLOS ONE, Public Library of Science, vol. 13(4), pages 1-23, April.
    13. de Martí, Joan & Zenou, Yves, 2015. "Network games with incomplete information," Journal of Mathematical Economics, Elsevier, vol. 61(C), pages 221-240.
    14. Zhang, Weiping & Zhuang, Xintian & Lu, Yang, 2020. "Spatial spillover effects and risk contagion around G20 stock markets based on volatility network," The North American Journal of Economics and Finance, Elsevier, vol. 51(C).
    15. Ferrari Minesso, Massimo, 2020. "Bank contagion in general equilibrium," Working Paper Series 2432, European Central Bank.
    16. Jean-Cyprien H'eam & Erwan Koch, 2014. "Diversification and Endogenous Financial Networks," Papers 1408.4618, arXiv.org, revised Feb 2015.
    17. Marek Lubiński, 2013. "Międzybankowy rynek pieniężny i zarażenie," Gospodarka Narodowa. The Polish Journal of Economics, Warsaw School of Economics, issue 5-6, pages 19-41.
    18. Ronald Fischer & Nicolás Inostroza & Felipe J. Ramírez, 2015. "Banking Competition and Economic Stability," Documentos de Trabajo 320, Centro de Economía Aplicada, Universidad de Chile.

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    More about this item

    Keywords

    Financial networks; interbank lending; interconnections; network centrality; spatial autoregressive models;
    All these keywords.

    JEL classification:

    • C21 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Cross-Sectional Models; Spatial Models; Treatment Effect Models
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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