How Does a Shock Propagate? A Model of Contagion in the Interbank Market Due to Financial Linkages

Abstract

In a setting with multiple banks and differential information, we study how a shock propagates in the banking system due to strategic interactions between banks' managers and depositors. We construct a model in which a bank faces an exogenous shock and study the transmission of this shock in the interbank market due to financial linkages. We uniquely determine the unfolding of the financial crisis in equilibrium. Firstly, we show that an initial shock to a bank is transmitted to the banking system, thus increasing the financial fragility. The more interesting part of our analysis, however, is the role played by creditor banks in transmission of the shock. We show that, under certain circumstances, creditor banks increase the fragility of borrower banks by unwinding their claims to distance themselves from the line of contagion. Furthermore, our model predicts that even when creditor banks do not directly play an important role on the financial distress of their borrower banks, they amplify the sensitivity of the initial shock on their borrower banks. Our model shows that not only does the interbank market transmit shocks -- and acts as a channel for contagion -- but also that the endogenous liquidity in the interbank market can be reduced after the initial shock, thereby increasing the fragility of the whole system over and above the initial shock.