Systemic Risk and Network Formation in the Interbank Market

Ethan Cohen-Cole (), Eleonora Patacchini and Yves Zenou
Additional contact information
Ethan Cohen-Cole: University of Maryland, Postal: Robert H Smith School of Business, 4420 Van Munching Hall, University of Maryland, College Park,, MD 20742, USA

No 2011:6, Research Papers in Economics from Stockholm University, Department of Economics

Abstract: We propose a novel mechanism to facilitate understanding of systemic risk in financial markets. The literature on systemic risk has focused on two mechanisms, common shocks and domino-like sequential default. Our approach is a formal model that provides an intellectual combination of the two by looking at how shocks propagate through a network of interconnected banks. Transmission in our model is not based on default. Instead, we provide a simple microfoundation of banks’ profitability based on classic competition incentives. As competitors lending quantities change, both for closely connected ones and the whole market, banks adjust their own lending decisions as a result, generating a ‘transmission’ of shocks through the system. We provide a unique equilibrium characterization of a static model, and embed this model into a full dynamic model of network formation with n agents. Because we have an explicit characterization of equilibrium behavior, we have a tractable way to bring the model to the data. Indeed, our measures of systemic risk capture the propagation of shocks in a wide variety of contexts; that is, it can explain the pattern of behavior both in good times as well as in crisis.

Keywords: Financial networks; interbank lending; interconnections; network centrality; spatial autoregressive models (search for similar items in EconPapers)
JEL-codes: C21 G10 (search for similar items in EconPapers)
Pages: 37 pages
Date: 2011-02-11
New Economics Papers: this item is included in nep-ban, nep-cba, nep-cis, nep-fmk, nep-net, nep-rmg and nep-ure
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (26)

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Working Paper: Systemic Risk and Network Formation in the Interbank Market (2011)
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Persistent link: https://EconPapers.repec.org/RePEc:hhs:sunrpe:2011_0006

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