Financial Contagion in Core–Periphery Networks and Real Economy

Abstract

The recent global financial crisis has revealed that borrowing and lending among banks and other financial intermediaries makes it possible for a shock to a single bank to spread through the entire system. One of the main sources of this chain-reaction is that financial intermediaries have come to indirectly hold many types of assets. Against this background, to provide a stylized representation of the interbank lending market, the present paper constructs a model in which banks’ liabilities form a core–periphery network. The model is then employed to simulate contagion in the network in the wake of the hypothesized insolvency of one of the banks. The main contributions of the analysis are as follows. First, the simulation shows that when asset prices declines as contagion spreads, the degree of contagion in response to an insolvency is significantly greater than when prices are assumed to be exogenous. Second, the core–periphery network analysis shows that insolvency increases non-monotonically in the strength of the links between core banks.