(), Eleonora Patacchini
() and Yves Zenou
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
Eleonora Patacchini: University of Roma La Sapienza, Postal: University of Roma La Sapienza, Box 83 Roma 62, P.le A. Moro 5, I-00185 Rome, Italy
Yves Zenou: Dept. of Economics, Stockholm University, Postal: Department of Economics, Stockholm University, S-106 91 Stockholm, Sweden
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.
37 pages, February 11, 2011
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