An economic model of contagion in interbank lending markets

Abstract

This paper examines the relationship between the structure of the interbank lending market and systemic risk. We consider a model in which banks finance investment opportunities through household deposits and borrowing from other banks. Using simulation techniques a range of interbank markets structures are considered. It is shown that greater levels of interbank connectivity reduce the risk of contagion from the failure of a single bank. In response to system wide shocks, however, the effect of connectivity is ambiguous, reducing contagion for small shocks but exacerbating it for larger events. Regulatory changes including forcing banks to hold more reserves, be less leveraged or constraining the size of borrowing relations are tested and their effects considered.