Abstract
Recent empirical evidence suggests that financial networks exhibit a core-periphery network structure. This paper aims at giving an explanation for the emergence of such a structure using network formation theory. We propose a general, stylized model of the interbank trading market, in which banks compete for intermediation benefits. Focusing on the role of bank heterogeneity, we find that a core-periphery network cannot be unilaterally stable when banks are homogeneous. A core-periphery network structure can form endogenously, however, if we allow for heterogeneity among banks in size. Moreover, size heterogeneity may arise endogenously if payoffs feed back into bank size.
Highlights
The extraordinary events of 2007 and 2008 in which the financial system almost experienced a global meltdown, has led to increased interest in the role of the financial network – the network of trading relationships and exposures between financial institutions1 – in systemic risk: the risk that liquidity or solvency problems in one institution spread to the entire sector
Financial relations are formed consciously by financial institutions who borrow, lend and trade financial assets with each other in order to maximize profits. This is important, as a change in the risk or regulatory environment may incentivize financial institutions to rearrange their financial links. This change may in itself constitute a financial crisis, for example in the case of an interbank market freeze, which may be interpreted as a sudden shift from a connected to an empty financial interbank network
Theorem 1 implies that empty, star, complete and multipartite networks can all arise within a network formation model with intermediation and imperfect competition
Summary
The extraordinary events of 2007 and 2008 in which the financial system almost experienced a global meltdown, has led to increased interest in the role of the financial network – the network of trading relationships and exposures between financial institutions1 – in systemic risk: the risk that liquidity or solvency problems in one institution spread to the entire sector. The model builds on work of Goyal and Vega-Redondo (2007) They show that, starting from ex ante identical agents, the star network with a single intermediating counterparty, quickly arises in an environment in which relations are costly.. Core banks tend to form a fully connected clique Such core-periphery networks are not stable in the framework of Goyal and Vega-Redondo (2007). In order to see if core-periphery networks are stable in an environment of imperfect competition for intermediation benefits, we adapt the framework of Goyal and Vega-Redondo (2007). We show that a stable core-periphery network may arise endogenously with ex ante identical banks, if one allows for a feedback loop from inequality in payoffs to inequality in size
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