A structural model of interbank network formation and contagion

Résumé

The interbank network, in which banks compete with each other to supply and demand financial products, creates surplus 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 network is not efficient, primarily because banks do not fully internalise a network externality in which their interbank links affect the default risk of other banks. A social planner would be able to increase surplus on the interbank network by 13% without increasing mean bank default risk or decrease mean bank default risk by 4% without decreasing interbank surplus. We propose two novel regulatory interventions (caps on aggregate exposures and pairwise capital requirements) that result in efficiency gains.