Contagious Synchronization and Endogenous Network Formation in Financial Networks

When banks choose similar investment strategies the financial system becomes vulnerable to common shocks. We model a simple financial system in which banks decide about their investment strategy based on a private belief about the state of the world and a social belief formed from observing the actions of peers. Observing a larger group of peers conveys more information and thus leads to a stronger social belief. Extending the standard model of Bayesian updating in social networks, we show that the probability that banks synchronize their investment strategy on a state non-matching action critically depends on the weighting between private and social belief. This effect is alleviated when banks choose their peers endogenously in a network formation process, internalizing the externalities arising from social learning.Comment: 41 pages, 10 figures, Journal of Banking & Finance 201

Systemic risk in a network model of interbank markets with central bank activity

The breakdown of the interbank money markets in the face of the recent financial crisis has forced central banks and governments to take extraordinary measures to sustain financial stability. In this paper we investigate which influence central bank activity has on interbank markets. In our model, banks optimize a portfolio of risky investments and riskless excess reserves according to their risk and liquidity preferences. They are linked via interbank loans and face a stochastic supply of household deposits. We then introduce a central bank into the model and show that central bank activity enhances financial stability. We model the default of a large bank and analyse the resulting contagion effects. This is compared to a common shock that hits banks who have invested in similiar assets. Our results indicate that common shocks are not subordinate to contagion effects, but are instead the greater threat to systemic stability.systemic risk, interbank markets, monetary policy, contagion, common shocks

Basel III and Systemic Risk Regulation - What Way Forward?

One of the most pressing questions in the aftermath of the financial crisis is how to deal with systemically important financial institutions (SIFIs). The purpose of this paper is to review the recent literature on systemic risk and evaluate the regulation proposals in the Basel III framework with respect to this literature. A number of shortcomings in the current framework are analyzed and three measures for future reform are proposed: counter-cyclical risk-weights, dynamic asset value correlation multipliers, and enhanced transparency requirements for SIFIs

The effect of the interbank network structure on contagion and financial stability

In the wake of the financial crisis it has become clear that there is a need for macroprudential oversight in addition to the existing microprudential banking supervision. One of the lessons from the crisis is that the network structure of the banking system has to be taken into account to assess systemic risk. There exists, however, no analysis on the influence of the network topology on contagion in financial networks. This paper therefore compares contagion in Barabási-Albert (scale-free) with Watts-Strogatz (small-world) and random networks. A network model of banks, a firm- and household-sector as well as a central bank is used. Banks optimize a portfolio of risky investments and risk-free excess reserves according to their risk and liquidity preferences. They form a network via interbank loans and face a stochastic supply of household deposits. Contagion effects from the default of a large bank are studied in different network topologies. The results indicate that contagion is more severe in random and scale-free networks than in small-world networks. This situation changes when the central bank is not active in which case small-world networks are less stable than scale-free and random networks. It is also shown that interbank liquidity above a certain threshold leads to endogenous instability, regardless of the network topology. The results further indicate that network heterogeneity does not contribute to financial instability

The effect of the interbank network structure on contagion and common shocks

This paper proposes a dynamic multi-agent model of a banking system with central bank. Banks optimize a portfolio of risky investments and riskless excess reserves according to their risk, return, and liquidity preferences. They are linked via interbank loans and face stochastic deposit supply. Evidence is provided that the central bank stabilizes interbank markets in the short-run only. Comparing different interbank network structures, it is shown that money-center networks are more stable than random networks. Systemic risk via contagion is compared to common shocks and it is shown that both forms of systemic risk require different optimal policy responses. --systemic risk,contagion,common shocks,multi-agent simulations

Endogenous money: on banking behaviour in new and post Keynesian models

In New Keynesian as well as in Post Keynesian macroeconomic models, money supply is assumed to be endogenous. The reasons for the endogeneity and the role of the financial sector in the supply process, however, are seen very different. In this paper we explicitly derive the behaviour of the banking sector regarding the supply of loans and the demand for reserves from portfolio and liquidity considerations. As a result, the money multiplier as well as the money base are endogenously determined. Although the microeconomics of the bank behaviour is quite simple, credit and money as well as bonds demand depend on policy variables in a non-linear and non-monotonous way

Systemic risk in a network model of interbank markets with central bank activity

The breakdown of the interbank money markets in the face of the recent financial crisis has forced central banks and governments to take extraordinary measures to sustain financial stability. In this paper we investigate which influence central bank activity has on interbank markets. In our model, banks optimize a portfolio of risky investments and riskless excess reserves according to their risk and liquidity preferences. They are linked via interbank loans and face a stochastic supply of household deposits. We then introduce a central bank into the model and show that central bank activity enhances financial stability. We model the default of a large bank and analyse the resulting contagion effects. This is compared to a common shock that hits banks who have invested in similiar assets. Our results indicate that common shocks are not subordinate to contagion effects, but are instead the greater threat to systemic stability

A Network View on Interbank Market Freezes

We study the liquidity allocation among European banks around the Lehman insolvency using a novel dataset of all interbank loans settled via the Eurosystem's payment system TARGET2. Following the Lehman insolvency, lenders in the overnight segment become sensitive to counterparty characteristics and banks start hoarding liquidity by shortening the maturity of their interbank lending. This aggregate change in liquidity reallocation is accompanied by a substantial structural change that can best be characterized as a shrinking of the interbank network. Such a change in the network structure is consequential: banks with higher centrality within the network have better access to liquidity and are able to charge larger intermediation spreads. Therefore, we show the existence of a sizeable interbank lending channel