Endogenous Bank Networks and Contagion

Abstract

I develop a model to study two related questions: how bank decisions to form connections depend on fundamentals; and how financial stability depends on bank network structure. In my model, banks are connected through two layers of networks: interbank debts and banks' common investments in non-financial firms. These layers of interconnections are incentivized by diversified investments when banks maximize their expected equity values according to mean-variance rules. I show that the topologies of the two network layers interact with each other. Comparative statics of a small number of banks indicates that, in equilibrium, as banks become less risk averse, they tend to issue more debts and form more links within the banking sector. Furthermore, I conduct numerical computations for bank default probabilities in a circle network and a more connected network. The results demonstrate that increased bank interconnectedness and common asset holdings significantly reduce systemic stability.