Working Paper: CEPR ID: DP10540
Authors: Iaki Aldasoro; Domenico Delli Gatti; Ester Faia
Abstract: 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 tâtonnement process which yields the equilibrium price, while traded quantities are determined by means of a matching algorithm. Contagion occurs through liquidity hoarding, interbank interlinkages and fire sale externalities. The resulting network configuration exhibits a core-periphery structure, dis-assortative behavior and low density. Within this framework we analyze the effects 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 tend to reduce risk (hence increasestability) without reducing significantly overall investment.
Keywords: banking networks; contagion; fire sales; prudential regulation; systemic risk
JEL Codes: C63; D85; G21; G28; L14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increasing liquidity requirements (G28) | Decrease systemic risk (G28) |
| Increasing liquidity requirements (G28) | Increase interbank interest rate (E43) |
| Increase interbank interest rate (E43) | Decrease investment in nonliquid assets (G11) |
| Increasing equity requirements (G32) | Decrease systemic risk (G28) |
| Liquidity requirements (G28) | More pronounced effect on systemic risk than equity requirements (F65) |