Research Papers in Economics, Department of Economics, Stockholm University
Systemic Risk and Network Formation in the Interbank Market
(), Eleonora Patacchini
() and Yves Zenou
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; (follow links to similar papers)
JEL-Codes: C21; G10; (follow links to similar papers)
37 pages, February 11, 2011
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