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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.

Suggested Citation

  • 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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    Citations

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    Cited by:

    1. Marco van der Leij & Daan in 't Veld & Cars Hommes, 2014. "The Formation of a Core Periphery Structure in Heterogeneous Financial Networks," Tinbergen Institute Discussion Papers 14-098/II, Tinbergen Institute, revised 11 Aug 2016.
    2. repec:eee:jbfina:v:80:y:2017:i:c:p:90-107 is not listed on IDEAS
    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. Blocher, Jesse, 2016. "Network externalities in mutual funds," Journal of Financial Markets, Elsevier, vol. 30(C), pages 1-26.
    6. 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.
    7. Zenou, Yves & König, Michael D. & Tessone, Claudio J., 2014. "Nestedness in networks: A theoretical model and some applications," Theoretical Economics, Econometric Society, vol. 9(3), September.
    8. 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.
    9. Tonzer, Lena, 2015. "Cross-border interbank networks, banking risk and contagion," Journal of Financial Stability, Elsevier, vol. 18(C), pages 19-32.
    10. repec:wsi:acsxxx:v:15:y:2012:i:supp0:n:s0219525912500865 is not listed on IDEAS
    11. de Martí, Joan & Zenou, Yves, 2015. "Network games with incomplete information," Journal of Mathematical Economics, Elsevier, vol. 61(C), pages 221-240.
    12. Jean-Cyprien H'eam & Erwan Koch, 2014. "Diversification and Endogenous Financial Networks," Papers 1408.4618, arXiv.org, revised Feb 2015.

    More about this item

    Keywords

    Financial networks; interbank lending; interconnections; network centrality; spatial autoregressive models;

    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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