Interconnectedness Among Banks, Financial Stability, and Bank Capital Regulation

Yehning Chen and Iftekhar Hasan

No 1643, BAFFI CAREFIN Working Papers from BAFFI CAREFIN, Centre for Applied Research on International Markets Banking Finance and Regulation, Universita' Bocconi, Milano, Italy

Abstract: This paper proposes that whether interconnectedness among banks leads to financial instability depends on banks’ leverage decisions. It extends the network model in Allen et al. (2012) to study the relationship between interconnectedness and the banks’ failure probability. In the model, banks adopt the Value-at-Risk rule to make the capital structure decisions and the risk of contagion is neglected. The paper finds that interconnectedness may either increase or decrease the banks’ failure probability. It also shows that interconnection is more harmful when banks are more over-optimistic about their prospects, and that financial integration may hurt financial stability. In addition, the adverse impact of interconnectedness on the banks’ failure probability can be alleviated if bank capital regulation is properly designed. This paper supports the conclusion in Allen and Gale (2000) that a complete financial system in which each bank is connected to all the other banks is superior to incomplete ones in which banks are connected to only a part of other banks.

Keywords: financial network; contagion; interconnectedness; diversification; bank capital regulation (search for similar items in EconPapers)
JEL-codes: G01 G21 (search for similar items in EconPapers)
Pages: 29 pages
Date: 2016
New Economics Papers: this item is included in nep-ban, nep-cba and nep-rmg
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Citations: View citations in EconPapers (1)

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