A Structural Model of Interbank Network Formation and Contagion

Abstract

The interbank network, in which banks compete with each other to supply and demand differentiated financial products, fulfils an important function but may also result in risk propagation. We examine this trade-off by setting out a model in which banks form interbank network links endogenously, taking into account the effect of links on default risk. We estimate this model based on novel, granular data on aggregate exposures between banks. We find that the decentralised interbank market is not efficient: a social planner would be able to increase surplus on the interbank market by 13% without increasing mean bank default risk or decrease mean bank default risk by 4% without decreasing interbank surplus. We then propose two novel regulatory interventions (caps on aggregate exposures and pairwise capital requirements) that result in efficiency gains.

Systemic risk prevention policies targeting systemically important banks: Does clustering pattern matter?

“…Poledna et al [ 5 ] then show that capital surcharges for G-SIBs introduced by Basel III are far less effective than SRT in controlling systemic risk. Coen and Coen [ 26 ] propose two tools to improve efficiency: caps on aggregate exposure and pairwise capital requirements based on the contagion intensity of each link. However, those policies are difficult to be applied in practice.…”

“…To distinguish whether the risk reduction comes from the decrease in interbank funds or the network arrangement, we further introduce the caps on aggregate interbank exposure. In Fig 13 , the blue dots give the results of caps on aggregate exposure proposed by Coen and Coen [ 26 ] by changing the expectations of interbank funds in Eq (3) . Also, results with caps on aggregate exposure are the control group, i.e., the linking relationships are unchanged, but the total transaction amount is reduced by a corresponding proportion.…”