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Title: Bank Networks: Contagion, Systemic Risk and Prudential Policy

Author(s): Ińaki Aldasoro, Domenico Delli Gatti and Ester Faia

Publication Date: April 2015

Keyword(s): banking networks, contagion, fire sales, prudential regulation and systemic risk

Programme Area(s): Financial Economics and International Macroeconomics

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 tātonnement 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.

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Bibliographic Reference

Aldasoro, I, Delli Gatti, D and Faia, E. 2015. 'Bank Networks: Contagion, Systemic Risk and Prudential Policy'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=10540