Interbank lending and the spread of bank failures

a network model of systemic risk

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Abstract

We model a stylized banking system where banks are characterized by the amount of capital, cash reserves and their exposure to the interbank loan market as borrowers as well as lenders. A network of interbank lending is established that is used as a transmission mechanism for the failure of banks through the system. We trigger a potential banking crisis by exogenously failing a bank and investigate the spread of this failure within the banking system. We find the obvious result that the size of the bank initially failing is the dominant factor whether contagion occurs, but for the extent of its spread the characteristics of the network of interbank loans are most important. These results have implications for the regulation of banking systems that are briefly discussed, most notably that a reliance on balance sheet regulations is not suffcient but must be supplemented by considerations for the structure of financial linkages between banks.
Original languageEnglish
Pages (from-to)583– 608
JournalJournal of Economic Behavior and Organization
Volume83
Issue number3
Early online date29 May 2012
DOIs
Publication statusPublished - Aug 2012

Fingerprint

Systemic risk
Lending
Network model
Bank failure
Banking system
Loans
Cash
Linkage
Transmission mechanism
Trigger
Balance sheet
Banking crisis
Contagion
Factors

Keywords

  • Interbank loans
  • Banking crises
  • Systemic risk
  • Network topology
  • Tiering
  • “Too big to fail”

Cite this

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title = "Interbank lending and the spread of bank failures: a network model of systemic risk",
abstract = "We model a stylized banking system where banks are characterized by the amount of capital, cash reserves and their exposure to the interbank loan market as borrowers as well as lenders. A network of interbank lending is established that is used as a transmission mechanism for the failure of banks through the system. We trigger a potential banking crisis by exogenously failing a bank and investigate the spread of this failure within the banking system. We find the obvious result that the size of the bank initially failing is the dominant factor whether contagion occurs, but for the extent of its spread the characteristics of the network of interbank loans are most important. These results have implications for the regulation of banking systems that are briefly discussed, most notably that a reliance on balance sheet regulations is not suffcient but must be supplemented by considerations for the structure of financial linkages between banks.",
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AB - We model a stylized banking system where banks are characterized by the amount of capital, cash reserves and their exposure to the interbank loan market as borrowers as well as lenders. A network of interbank lending is established that is used as a transmission mechanism for the failure of banks through the system. We trigger a potential banking crisis by exogenously failing a bank and investigate the spread of this failure within the banking system. We find the obvious result that the size of the bank initially failing is the dominant factor whether contagion occurs, but for the extent of its spread the characteristics of the network of interbank loans are most important. These results have implications for the regulation of banking systems that are briefly discussed, most notably that a reliance on balance sheet regulations is not suffcient but must be supplemented by considerations for the structure of financial linkages between banks.

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