DP10540 Bank Networks: Contagion, Systemic Risk and Prudential Policy

Author(s): Iñaki Aldasoro, Domenico Delli Gatti, Ester Faia
Publication Date: April 2015
Keyword(s): banking networks, contagion, fire sales, prudential regulation, systemic risk
JEL(s): C63, D85, G21, G28, L14
Programme Areas: International Macroeconomics, Financial Economics
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=10540

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.