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Only Paul Could Go To Changchun

Bank Networks: Contagion, Systemic Risk and Prudential Policy 

1/25/2017

 
Here.

We present a network model of the interbank market in which optimizing risk averse banks lend to each other and invest in non-liquid assets. Market clearing takes place through a tˆatonnement process which yields the equilibrium price, while traded quantities are determined by means of an assortative matching process. Contagion occurs through liquidity hoarding, interbank interlinkages and fire sale externalities. The resulting network configuration exhibits a coreperiphery structure, dis-assortative behavior and low density. Within this framework we analyze the effects of a stylized set of prudential policies on the stability/efficiency trade-off. Liquidity requirements unequivocally decrease systemic risk, but at the cost of lower efficiency (measured by aggregate investment in non-liquid assets). Equity requirements also tend to reduce risk (hence increase stability), though without reducing significantly overall investment. On this basis, our results provide general support for the Basel III approach based on complementary regulatory metrics. 

From:

Iñaki Aldasoro
Bank for International Settlements

Domenico Delli Gatti
Catholic University of Milan

Ester Faia 
Goethe University Frankfurt & CEPR

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