Network topology and interbank credit risk

Abstract

Modern financial systems are greatly entangled. They exhibit a complex interdependence, including a network of bilateral exposures in the interbank market. The most frequent interaction consists in operations where institutions with surplus liquidity lend to those with a liquidity shortage. These loans may be interpreted as links between the banks and the links display features in some way representative of scale-free networks. While the interbank market is responsible for efficient liquidity allocation, it also introduces the possibility for systemic risk via financial contagion. Insolvency of one bank can propagate through links leading to insolvency of other banks. In this paper, we explore the characteristics of financial contagion in interbank networks whose distribution of links approaches a power law, as well as we improve previous models by introducing a simple mechanism to describe banks’ balance sheets, that are obtained from information on network connectivity. By varying the parameters for the creation of the network, several interbank networks are built, in which the concentration of debt and credit comes from the distribution of links. The results suggest that more connected networks that have a high concentration of credit are more resilient to contagion than other types of networks analyzed.