A structural model of interbank network formation and contagion

Staff working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 11 October 2019

Staff Working Paper No. 833

By Patrick Coen and Jamie Coen

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.

PDFA structural model of interbank network formation and contagion

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