Endogenous Bank Networks and Contagion

Jieshuang He ()
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Jieshuang He: Indiana University

No 2016-005, CAEPR Working Papers from Center for Applied Economics and Policy Research, Department of Economics, Indiana University Bloomington

Abstract: I develop a model to study two related questions: how bank decisions to form connections depend on fundamentals; and how financial stability depends on bank network structure. In my model, banks are connected through two layers of networks: interbank debts and banks' common investments in non-financial firms. These layers of interconnections are incentivized by diversified investments when banks maximize their expected equity values according to mean-variance rules. Comparative statics of a small number of banks indicates that, in equilibrium, as banks become less risk averse, they tend to issue more debts and form more links within the banking sector. Furthermore, I conduct numerical computations for bank default probabilities in a circle network and a more connected network. The results demonstrate that increased bank interconnectedness and common asset holdings significantly reduce systemic stability.

Keywords: Endogenous Network; Financial Contagion; Interbank Debt; Portfolio Selection (search for similar items in EconPapers)
JEL-codes: D85 G11 G20 (search for similar items in EconPapers)
Pages: 47 pages
Date: 2016-11
New Economics Papers: this item is included in nep-ban and nep-cmp
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