Bank Networks: Contagion, Systemic Risk and Prudential Policy

Journal of Economic Behavior and Organization, Vol. 142, pp.164-188

Iñaki Aldasoro,
Domenico Delli Gatti,
Ester Faia
Research Area:
Macro and Finance
Oct 2017
Banking networks; Systemic risk; Contagion, Fire sales, Prudential regulation

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 an assortative matching process. 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 a stylized set 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 also tend to reduce risk (hence increase stability), though without reducing significantly overall investment. On this basis, our results provide general support for the Basel III approach based on complementary regulatory metrics.

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