Risk Cascades in Banking Networks and the Measurement of Systemic Risk

Topic and Objectives

The propagation of bank losses which turned a shock to a small segment of the US financial system (the sub-prime mortgage market) into a large global banking crisis in 2007/2008 was due to multiple channels of contagion: liquidity hoarding due to banks’ precautionary behavior, direct cross-exposures in interbank markets and fire sale externalities. We explore those three channels by focusing on liquidity hoarding and by building an interbank network with risk averse banks who solve non linear portfolio optimization while being linked to other banks in interbank markets and through asset commonality (the latter links modeled along the lines of Bluhm, Faia and Krahnen, SAFE WP 12 and SAFE WP 46). We find that liquidity hoarding is crucial to account for the bulk of contagion and systemic risk propagation. We also examine the impact of prudential policy measures in our networks

Key insights

• Key role of liquidity hoarding channel
• Our banking network can replicate major empirical facts on assortativity, clustering and other network metrics
• We find a strong connection between banks' contribution to systemic risk and banks’ assets (borrowing and non-liquid assets).
• In terms of the policy analysis, we find that increasing the liquidity requirement unequivocally reduces systemic risk and the contribution of each bank to it. The strong reduction in non-liquid assets is induces costs to it in terms of system efficiency, highlighting the existing trade-off between stability and efficiency.
• An increase in the equity requirement instead does not present this strong trade-off.

This project was funded by: