Incentivizing Resilience in Financial Networks

Matt V. Leduc and Stefan Thurner

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Abstract: When banks extend loans to each other, they generate a negative externality in the form of systemic risk. They create a network of interbank exposures by which they expose other banks to potential insolvency cascades. In this paper, we show how a regulator can use information about the financial network to devise a transaction-specific tax based on a network centrality measure that captures systemic importance. Since different transactions have different impact on creating systemic risk, they are taxed differently. We call this tax a Systemic Risk Tax (SRT). We use an equilibrium concept inspired by the matching markets literature to show analytically that this SRT induces a unique equilibrium matching of lenders and borrowers that is systemic-risk efficient, i.e. it minimizes systemic risk given a certain transaction volume. On the other hand, we show that without this SRT multiple equilibrium matchings exist, which are generally inefficient. This allows the regulator to effectively stimulate a `rewiring' of the equilibrium interbank network so as to make it more resilient to insolvency cascades, without sacrificing transaction volume. Moreover, we show that a standard financial transaction tax (e.g. a Tobin-like tax) has no impact on reshaping the equilibrium financial network because it taxes all transactions indiscriminately. A Tobin-like tax is indeed shown to have a limited effect on reducing systemic risk while it decreases transaction volume.

Date: 2016-06, Revised 2017-06
New Economics Papers: this item is included in nep-ban and nep-net
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Citations: View citations in EconPapers (14)

Published in Journal of Economic Dynamics & Control 82 (2017) 44-66

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Journal Article: Incentivizing resilience in financial networks (2017)
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Persistent link: https://EconPapers.repec.org/RePEc:arx:papers:1606.03595

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